As the Federal Reserve struggles to tame inflation, the central bank is raising interest rates and tightening financial conditions in what we think is a regime change that will increase the cost of both public and private debt and curb growth.
We expect the Fed to raise its policy rate above 5% in the near term while at the same time reducing its balance sheet by $95 billion per month.
We expect the Fed to raise its policy rate above 5% in the near term while at the same time reducing its balance sheet by $95 billion per month. At that pace, the Fed’s balance sheet will fall to pre-pandemic levels by the summer of 2026.
There are other factors affecting financial conditions as well, including the government’s multi-billion-dollar effort to jumpstart the high-value semiconductor industry, the trillion-dollar rebuilding of domestic infrastructure and a push to reduce an over-reliance on fossil fuels.
All of these initiatives will increase the competition for scarce private capital for the foreseeable future.
After decades of disinflation and declining interest rates, financial markets are adjusting their estimate of the appropriate level for interest rates, forcing the real economy to balance the higher costs of credit with the need to invest in productivity.
Consider the benchmark 10-year Treasury bonds, which have moved above 4% for the first time since 2007. How much higher should we expect this yield to move in this tightening cycle?
In the near term, we anticipate the 10-year yield to finish the year at or above 4.25%. Over the next year, we expect that 10-year yield to peak and then trend down toward 4% by the end of next year in anticipation of rate cuts by the Fed to support what will be an economy in recession.
As for the medium term, we start with the simple fact that interest rates are determined by, first, expectations for inflation and the response to that inflation by the monetary authorities, and, second, the risk of holding securities until maturity.
As to the first component, interest rates will move lower during periods of disinflation. In periods of increased inflation, interest rates will rise, led by the Fed’s policy rate.
A simple relationship shows a 96% correlation between 10-year Treasury yields and expectations for inflation in 10 years.
In the middle of November, the forward market is anticipating 4% inflation in 10 years, which implies a 10-year yield of only 3.3%. But that is 80 basis points lower than the actual yield of 4.15%, with the difference encompassing uncertainty over the success of Fed policy and the uncertainty of economic growth.
We expect the 10-year yield to float higher, toward 4.25% by the end of the year with the risk of a higher rate.
The second component—referred to as the term premium—includes the risk of inflation moving higher or lower than expectations. For instance, if inflation were to exceed expectations, then the Fed would need to push short-term rates higher, causing a bond market sell-off that would reduce the value of holding that security.
Analysis at the New York Fed by Richard K. Crump, Charles Smith and Peter Van Tassel finds that the term premium for holding bonds was high when interest rates were elevated (as high as 5% during the 1980s), receded as interest rates declined and have been negative since 2015.
In our view, negative values of the term premium during the previous decade reflected the lack of confidence in government actions during the prolonged recovery from the 2008-09 Great Recession and the threat of outright deflation had those policy disruptions or the trade war continued.
The slightly negative term premium in recent months suggests wariness of yet another debt ceiling standoff and an economic slowdown next year.
In 2007, and in similar circumstances, the business cycle was peaking, inflation was exceeding 4% and 10-year bond yields were trading in the 4% to 5% range. Back then, interest rates in that range seemed normal. After years of near-zero interest rates, what seems normal now?
The near term
We agree with the New York Fed’s analysis that given the recent rise in inflation, there will be a commensurate increase in term premiums. Still, the term premium on short-dated securities will remain relatively small, with current market prices reflecting investors’ expectations for monetary policy over the near term.
In the medium-term—and assuming the eventual end of the debt ceiling debate, the success of Fed policy to stabilize prices and the return to a slow-growth environment—we anticipate a pause in Fed rate hikes next year and an eventual cut.
Fed policy is nimble and will reverse course once prices have stabilized or if the economy is unable to support higher rates. For instance, the Fed maintained its near-zero policy rate from 2009 to 2015 while the economy struggled and then again during the pandemic.
We expect the federal funds rate to increase from 4% to above 5% for as long as the core Personal Consumption Expenditures index, a closely watched measure of inflation, remains above 5%.
By the end of the first quarter, the federal funds rate will top out most likely between 5% and 5.25%. That implies an increase in interest rates along the entire yield curve, with 10-year Treasury yields pushing to the top of a 4% to 5% range preceded by moves in two-year and five-year yields.
But what will determine the level of normal interest rates in the next phase of economic growth?
The longer term
Our assessment is that a shift in structure is occurring in the real economy and financial markets. We anticipate that economic growth will either slip into a near-recession next year because of the global tightening of monetary policy or fall into outright recession if circumstances in Europe or Asia worsen, or if Congress embraces fiscal austerity.
In either case, we expect the U.S. economy to stagnate, with annual growth limited to 1.5%, a notch below the 1.8% that was the long-term average before the pandemic
Recall that short-term bond yields are directly affected by monetary policy, with two-year yields representing the present value of expectations for short-term money market rates over two years.
But yields on long-term bonds—while still affected by changes in the policy rate—are more likely to include perceptions of economic growth and the real return on investment.
For example, mortgage rates in November moved above 7% for the first time since the early-2000s housing bubble, while the yield on 10-year Treasury bonds exceeded 4% for the first time since before the Great Recession.
We suspect that this latest increase will mark the end of near-zero interest rates, for several reasons:
Increase in the Fed’s inflation target: After the shock of the pandemic, it might be more realistic for the Fed to announce an inflation target higher than the current 2%. Not only have housing prices proven to be sticky, but businesses and consumers are also facing higher structural costs.
Liquidity constraints: We expect the Fed to continue to draw down its balance sheet without new economic shocks. The absence of the Fed purchases should pressure interest rates higher in the near term, with a liquidity crisis a distinct possibility should the global economy force the issue.
At the opposite end of the spectrum, should inflation end quickly or unemployment deteriorate dramatically, the Fed would be expected to reverse course as it did during the trade war and the pandemic, when the Fed resumed its asset purchase program.
Rising food and energy prices: Inflation will dominate public opinion as long as gasoline and food prices remain high, with the circular effect of increasing inflation expectations. After all, food and energy have a combined weight of 22% in the Consumer Price Index and have a significant effect on consumer sentiment.
Because prices for these fungible items are determined on a global market, there is not much we can expect the Fed to do other than to raise interest rates and discourage the accumulation of credit.
And because of supply constraints, we expect gasoline and fertilizer prices to remain high while developed economies transition away from fossil fuels. We also expect food prices to remain high as Russia’s war in Ukraine drags on.
Moderating the impact of those price increases requires fiscal incentives to promote the transition from fossil fuels and the expansion of programs for food sufficiency among poorer nations.
The effect of uncertainty
The war in Ukraine is expected to take a bigger toll on the United Kingdom and Euro-area economies than on North America, which is less dependent on OPEC+ for oil and natural gas.
But energy prices are global and are set according to OPEC production levels. They have an equal impact on U.S. inflation and monetary policy, and therefore energy prices directly affect the direction of the U.S. economy.
When energy prices surge or other shocks take place, the risk premium for issuing corporate debt tends to increase.
At present, lenders are requiring increased compensation from borrowers to cover the risk of recession and diminished demand, with the yield spread between investment-grade corporate debt rising above two percentage points. Riskier high-yield debt is now requiring four to five additional percentage points of compensation.
The takeaway
Because it will take years to unwind from the shocks of shortages of energy, food and other goods, we anticipate years of inflation being higher than what we’ve come to expect.
We can anticipate the Fed adopting a higher inflation target in the range of 3% to 4%, with Treasury bond yields remaining in the range of 4% to 5% even as growth slows next year.
Because of the increase in uncertainty, we anticipate that investors will require a higher risk premium for holding business debt. Recent experience suggests an investment-grade corporate premium of three percentage points over Treasury yields should the economy enter recession next year.
