The bond market is preparing for what could be a monumental shift in the Federal Reserve's inflation strategy.

Fed Chairman Jerome Powell's speech on Aug. 27 is expected to lay the groundwork for the Fed to explicitly tolerate inflation above its 2% target once the U.S. economic recovery is in full swing. Investors will likely need to wait until September for the full details, but the announcement would mark a major change from the Fed's decades-long approach to managing inflation.

The changes have been in the works since before the coronavirus hit, but markets do not yet seem convinced they will help the Fed meet its 2% inflation target. Breakeven inflation rates — yields on regular Treasury bonds minus yields on Treasury Inflation-Protected Securities, or TIPS — indicate that markets see inflation averaging 1.67% over the next 10 years.

While that is a significant recovery from the 0.5% level during the markets' pandemic panic this March, there is still a "ways to go" to get close to markets pricing in the likelihood of 2% inflation, said Jonathan Hill, a U.S. rates strategist at BMO Capital Markets.

"[One] reason why we're not there yet is there are a lot of market participants who are skeptical that the Fed will be able to achieve an average of 2% inflation going forward," he said.

The Fed's new approach would mark a major departure from its traditional response to inflation: tamp it down preemptively with interest rate increases as soon as inflation pressures emerge. Instead, the Fed would keep interest rates low for a longer period of time, as part of an effort to lift inflation above 2% temporarily to make up for any dis-inflationary impacts of a recession. The goal would be to ensure inflation hits 2% on average by letting inflation spend as much time above 2% as it did below it.

Lower rates would give the U.S. job market more room to achieve a broad-based recovery from its worst shock in decades, analysts say. They would also be good news for the stock market, with low bond yields pushing more investors into higher-yielding stocks and investors likely being less worried that Fed rate hikes will choke off an economic expansion prematurely.

"Basically, the Fed [would be] saying: 'We're not going to stand in the way. We're not going to take away the punch bowl as early as we have in the previous cycles,'" Hill said.

Powell will be speaking at the Kansas City Fed's annual economic policy symposium, which usually draws central bankers from around the world to a mountain retreat in Jackson Hole, Wyo. This year, however, the conference will be held virtually and live-streamed to the public for the first time since it started in 1978.

To a certain extent, the shift in the Fed's inflation strategy happened informally before the coronavirus pandemic hit. Fed officials have long emphasized that their 2% inflation target is "symmetric," signaling they would welcome above-target inflation given the persistent undershooting of their 2% goal since the 2007-09 financial crisis.

The changes will mostly be "codifying the way we're already acting with our policies," Powell told reporters on July 29. They stem from a broad review the Fed launched in 2019 of its overall monetary policy framework, a major takeaway of which has been that the relationship between falling unemployment and rising inflation is not as strong as previously thought.

The Fed, like other major central banks, has tried to grapple with the effectiveness of its tools in a world where inflation is naturally held down by technology, globalization and an aging population's changing spending patterns, to list three often-cited culprits.

Bank of America analysts are cautioning investors to avoid "overhyping" the Fed's changes, partly because those structural factors "have an arguably larger impact on inflation" than Fed policy.

Treasury real yields, or yields without inflationary impacts, have tumbled deeply into negative territory after spiking in March. The real 10-year Treasury yield fell to -1% on Aug. 21, down from a peak of 0.62% on March 19. Real yields, while still negative, appear to have steadied since the first week of August.

After a recent, steep decline, nominal Treasury yields have also held relatively steady. The 10-year yield, for example, has remained between 0.64% and 0.71% since Aug. 11 after tumbling to 0.52% on Aug. 4.

Mark Haefele, chief investment officer with UBS, said that 10-year Treasury yields typically rise with rallies in equities and improving economic growth. But these yields have remained flat in August even as stocks reached record highs, likely due to the Fed policy outlook.

"We think the 10-year yield is signaling that the Fed will keep rates low for a long time, even if inflation rises," Haefele wrote in an Aug. 20 research note. "The likelihood of very low rates for an extended period makes investors willing to pay more for a given dollar of earnings."

Bonds have yet to fully price in Fed policy change

The pandemic put a major dent on overall inflation early in the pandemic, with the Fed's preferred gauge — the core personal consumption expenditures price index — rising by 0.9% year over year in June compared to 1.9% in February. More recent consumer price index data showed strengthening in July, indicating that inflation may have already bottomed out.

But bond markets seem skeptical that the Fed's strategy switch will actually yield 2% inflation as the economy recovers. They do not have to look far to question the Fed's inflation track record. The economic recovery following the 2007-09 financial crisis was the longest on record, but inflation remained stubbornly below 2% for much of it.

Although breakeven inflation rates might suggest that market-based inflation expectations have risen, much of the increase appears to be due to improved liquidity in TIPS.

TIPS market conditions were slower to recover than those for the regular Treasurys market, as the inflation-protected securities are traded less often and are therefore less liquid, said Aneta Markowska, chief financial economist at Jefferies Group LLC. She used breakeven models created by Fed economists to show that changes in the TIPS liquidity premium explain much of the increase in breakevens and that market-based inflation expectations have been virtually flat since late March.

"Inflation breakevens are rising, but it doesn't mean inflation expectations are rising," Markowska said.

Flows into U.S. TIPS funds have increased by about $10.7 billion since the beginning of May, after declining by about $8.4 billion from mid-March through April, according to EPFR Global.

Formal changes expected in September, with more action likely on tap

Powell's speech is expected to guide the public through the Fed's considerations in reassessing its inflation strategy, without giving away all the details on the changes themselves. Those would likely have to wait until the next Federal Open Market Committee meeting on Sept. 15-16, analysts say.

The formal changes would occur in the Fed's "Statement on Longer-Run Goals and Monetary Policy Strategy," which outlines the Fed's approach to meeting its dual mandate of stable prices and maximum employment.

The Fed, however, will likely avoid opting for any formal rules that would bind officials, current or future ones, to a mechanical process of setting interest rates. The changes will instead give the Fed "total discretion to do whatever it wants, whenever it wants," said Mickey Levy, chief economist for the Americas and Asia at Berenberg Capital Markets LLC.

"It wants to word it in a way that provides it with total flexibility but at the same time give the impression that it wants inflation to go above 2%," he said.

The action would then open the door to other policy changes that Fed officials have discussed, analysts say. Key among those is the Fed's so-called forward guidance on how long it will keep its benchmark rate at near-zero levels.

Right now, the FOMC's statement says it expects to keep rates unchanged until officials are "confident that the economy has weathered recent events" and is back on track. Fed officials have debated whether they should make that guidance more explicit, perhaps by giving a specific date or by outlining certain thresholds that economic data has to meet before a rate hike is considered.

And although Fed officials appear to have ruled out capping parts of the yield curve for now, they could restructure their current asset purchase program toward one explicitly aimed at keeping long-term yields low, said Markowska, the Jefferies economist. The primary rationale for the current program is still to support "smooth market functioning," even after the vast improvement in liquidity for Treasurys since March and April.

But a new QE program specifically designed to lower long-term rates and encourage borrowing could help the Fed convince markets that its new inflation approach is more than just talk, Markowska said.

"If you want a policy to be credible, you have to explain to the market what you're going to do differently," she said.