Over the past three years, the core analytical framework we have used to understand the post-pandemic economy is that a fundamental structural shift, or regime change, is taking place.
Gone is the era of low inflation and low interest rates. In its place is a new framework featuring scarce capital and higher rates.
It’s this shift that explains why long-term interest rates have been rising even as the Federal Reserve has reduced its policy rate—and why financial markets have been experiencing considerable volatility.
Gone is the era of secular stagnation characterized by low inflation, low interest rates, a global savings glut and sagging aggregate demand.
In its place is a new framework featuring scarce capital, insufficient aggregate supply, higher inflation and higher interest rates.
Taken together, these changes have significant implications for monetary and fiscal policies as a new Trump administration takes over.
Structural change
The previous era of low interest rates and low inflation, which held from 1990 to 2020, was defined by the integration of China and its prodigious production potential into the global economy.
That era unleashed a wave of deflation that continued until the combination of pandemic-era shocks and populist economics ended it.
Low-wage production inside China was accompanied by policies and incentives to save rather than spend.
The result was a transfer of wealth through China’s banking system to manufacturing entities that exported excess goods, supported China’s rapid modernization and generated excess savings, much of which was invested in U.S. Treasury instruments.
In the U.S., China’s economic rise helped usher in a period of deflation, all while driving down interest rates and dampening global investment.
But then the pandemic hit. Supply chains were shut down, global inflation surged and China’s commercial and residential sectors collapsed. This shock was accompanied by the rise of economic populism and trade protectionism in the West.
Read RSM’s global economic outlook for 2025 in the latest issue of The Real Economy.
Now, the global economy is experiencing a regime change featuring a normalization of interest rates and inflation. This era will require a shift in monetary and fiscal policies at a time when public expectations have yet to adjust.
New policies aimed at bolstering vital national industries and infrastructure all will most likely keep interest rates at or above current levels.
As the global savings glut and dampened investment fade, the competition for capital between public and private sector actors is intensifying.
This explains the rapid shift of global capital flows into artificial intelligence and the buildout of data centers and energy infrastructure to support the next economic revolution.
For the first time in two decades, capital is growing scarce and the cost of financing business expansion is increasing amid rising demand for funds, in both the private and public sectors.
State of play
A seeming contradiction is taking place: As the Federal Reserve has pushed its policy rate lower, long-term interest rates have been rising.
Since the Federal Reserve cut its policy rate by 50 basis points in September, the yield on the 10-year Treasury note has increased by as much as 117 basis points (1.17%).
This dynamic has been felt across financial markets, causing considerable volatility in equity valuations which has disrupted the correlation between stocks and bonds over the past two decades.
Investors had become accustomed to an inverse correlation between those financial instruments—as yields decline, stocks rise and vice versa. But recently, both have been moving in the same direction as occurred following the blowout U.S. jobs report in December.
It is understandable why risk aversion would creep into investor and firm expectations, which could dampen an otherwise sunny economic outlook.
However, for those with longer memories, a rising term premium is consistent with the regime change in financial markets and the economy, and the heightened risk that has accompanied this change.
Resurgent inflation
In the 18 years before the financial crisis, an inflation rate of 2% or lower was achieved in just 36% of the months, using the Fed’s preferred measure of inflation, the personal consumption expenditures index.
This period included the two mild recessions of the early 1990s and 2000 as well as technological advances and a burst of productivity from 1995 to 2000.
Compare that to the decade after the financial crisis from 2010 to 2020. The rise of China’s factory floor and the development of the global instant-access supply chain sent price levels to such low levels that U.S. manufacturing could no longer compete.
The PCE inflation rate was 2% or lower in 82% of the months in that period, with the inflation rate bordering on deflation in 2015 during the collapse of commodity prices and oil. Deflation can result in a spiral that can lead to economic collapse, with the 1930s Depression being the prime example.
After the inflation shock spurred by the pandemic and the war in Ukraine, the PCE index returned to 2.4% at year-end 2024. The Fed projections are for the PCE to finish this year at 2.5% and not achieve its 2% target until the end of 2027.
Those projections raise two important questions.
- Is the 2% target for inflation realistic option? Western economies are trying to disengage from China by adopting industrial policies and moving production closer to home. It would not take much in the way of supply chain disruptions to cause shortages and send prices creeping higher.
- Should the Fed adopt a more flexible inflation target? For instance, would adopting a 2% to 3% target range, with a 2.5% central target make more sense? • Should inflation linger much longer above the Fed’s 2% target, then investors will begin factoring a de-facto inflation target of their own probably between 2.5% and 3%.
The labor market
If markets were perfect, wages would rise when labor was in short supply, and to fall when there is a surplus of labor.
This was the case in each of the business cycles since 1980 other than the distortions of the pandemic shutdown in 2020 and its aftermath.
The consensus in the post-war era was that if wages were to rise, then the price of goods would rise, creating a so-called wage-price spiral. After all, it made sense that employers would maintain their profit margins by passing along the higher cost of labor onto consumers.
From 1988 until 2002, there is an inverse relationship between hourly wage growth and the unemployment rate. As the supply of available labor increases, proxied by increased unemployment with workers willing to accept lower wages, then wage growth moves lower.
But that slice was before the dismantling of the U.S. production that intensified during the financial crisis. The American economy is now dominated by the service sector, with jobs in goods production making up 16% of total employment. A narrower definition of the manufacturing workforce implies it has declined to 8%.
Looking at the period from 2012 to 2024 (and excluding the pandemic distortions in unemployment and wage growth during 2020 to 2023), the relationship between labor supply and wage growth has shifted lower and is flatter.
The flatness of the Phillips curve suggests the less-dramatic relationship among the supply of labor, wage growth and ultimately inflation. We expect this continue, absent a further shock.
Instead, the market appears to have reached a steady state, adjusting to the lower wages in the service sector. The impact of those changes has led to an increase in entrepreneurship that should benefit the overall economy.
The onset of tighter immigration policies with an economy at full employment as the Phillips curve flattens denotes a risk of a decline in the unemployment rate and a jump in wages.
Under such conditions, interest rates would rise and so would the Fed’s policy rate as the central bank turns to managing risks around a wage-price spiral.
The potential for growth
This Congressional Budget Office finds that the economy has the potential to grow at a rate of 2% per year through 2030.
The most recent surge in potential U.S. growth occurred in the 1990s, when micro-computing took hold of how we find and use information. After rising to 4% potential growth, the economy has since settled into a 2% groove.
If there is reason for a surge in optimism regarding U.S. growth, it again comes from the technology sector and the development of increasingly fast computer chips. These chips, made mostly overseas, are on the verge of being produced in the United States.
A secure supply of semiconductors, whether for a toaster or artificial intelligence, suggests more room for the economy to grow.
But if that recent surge in productivity is not sustained, then a quick pace of growth will accentuate the competition for scarce capital and raise interest rates.
The end of easy money
The interest rate on a 10-year Treasury bond is approaching 5%, a significant shift after a decade of bond yields as low as 1%. The era of near-zero borrowing costs has ended.
This change implies the normalization of interest rates to reasonable levels and perhaps the moderation of speculative behavior that has distorted the direction of investment over the past 15 years.
Interest rates are determined by expectations of monetary policy and the setting of the Fed’s overnight rate, and by a risk premium that accounts for potential changes in monetary policy.
This risk premium is referred to as the term premium. A positive value of the term premium is associated with normal (positive) levels of inflation. Negative or near-zero levels of the term premium are associated with the risk of deflation and the risk of economic collapse.
So, at this moment, the perceived direction of monetary policy has become more accommodative. The Fed cut the overnight rate by 100 basis points to 4.5% last year and the market is anticipating reductions of another 50 basis points by the end of this year.
Add to that the increased confidence that the economy will grow at an above-potential pace and be able to support normal levels of the rate of return on investment. The result of this reduced risk is a 10-year Treasury trading within the pre-financial crisis range of 4% to 5%.
The importance of financial conditions
Since the 2008-09 financial crisis, the financial markets have been disrupted by geopolitical and policy shocks, resulting in the era of near-zero interest rates and ushering in an era of speculation in asset markets.
There is cause for optimism, however. The RSM US Financial Conditions index, which bottomed out after the 2022 onset of the Ukraine war, has since been on an uptrend and has been moderately positive since September 2024.
These positive readings are the result of the steadiness of monetary policy and the judicious use of fiscal policy to make concrete investments in productivity and the growth of the economy.
We expect these positive levels of financial conditions to continue to signal the willingness to invest in economic growth and the renewed importance of a normally operating financial sector.
The financial markets have responded with reduced volatility, with the normalization of interest rates now offering safer investments that rival the risk-adjusted returns of more speculative financial assets.
The takeaway
The regime change that is occurring in real time across the U.S. and global economies is going to upend policy frameworks that have characterized the past generation.
Governments that have tended to increase social welfare safety nets to provide a cushion against technological and economic change will face challenges in financing those efforts in the face of rising interest rates amidst scarce capital.
The economic populists that are on the rise who favor expansionary fiscal policies will face similar challenges.
Whether one is a left wing or right wing populists economies that have rested on plentiful fiscal space and easy monetary policy now face a difficult period of adjustment to an era of intensifying competition for capital, insufficient aggregate supply, higher inflation and higher interest rates.
Such is the price of regime change.
