Top central bank officials have signaled in recent days that they could be done raising short-term interest rates if long-term rates remain near their recent highs and inflation continues to cool.
The Fed raises rates to combat inflation by slowing economic activity, and the main transmission mechanism is through financial markets. Higher borrowing costs lead to weaker investment and spending, a dynamic that is reinforced when higher rates also weigh on stocks and other asset prices.
The upshot: If the run-up in the 10-year Treasury yields to their highest levels since 2007 persists, those increases could substitute for additional rises in the fed-funds rate.
Officials initially chalked up the increase in long-term rates to better economic news. That prompted bond investors to reduce bets that a recession would prompt the Fed to lower interest rates in the first half of next year.
But the rise in rates increasingly appears to be driven by factors that can’t be as easily explained by the economic or Fed policy outlook, with rising government deficits a prime suspect. This suggests the so-called term premium—or extra yield that investors demand for investment in longer-dated assets—is rising.
“If long-term interest rates remain elevated because of higher term premiums, there may be less need to raise the fed-funds rate,” Dallas Fed President Lorie Logan, a voting member of the Fed’s rate-setting committee, said on Monday. Logan’s remarks were a notable shift from a Fed official who has been a leading advocate for higher rates this year.
Term premiums are difficult to measure precisely. Logan outlined three different approaches and concluded that, across all three measures, at least half of the increase in long-dated Treasury yields since the end of July reflects higher term premiums.Together, their comments suggest the Fed is on course to hold rates steady at their Oct. 31-Nov. 1 meeting. Then Fed officials could wait to see how economic and financial developments unfold next month before deciding whether to raise rates in December.Asset managers say the rise in term premiums in recent weeks has been driven by investors grappling with higher-than-anticipated government-debt issuance to finance larger U.S. deficits. Higher term premiums could weigh on investment, spending and hiring if they push down prices of stocks and other assets. “Asset prices thus far have stayed really, really elevated,” Khurana said. “If we have more of a term-premium ‘normalization,’ you could see a world where asset prices move down and owners of assets suddenly are not as willing to spend as they had been in the last year.”
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