The Bond Market Is Daring The Fed To Raise Rates
The Federal Reserve has spent months letting the bond market do some of its tightening for it. With the 30-year Treasury yield now above 5.3% and other long-term borrowing costs climbing, that arrangement is becoming harder to sustain: the market is increasingly signaling that keeping the Fed’s own policy rate unchanged isn’t enough to restore confidence that inflation will come back under control.
The pressure is visible in real yields, which strip out expected inflation and show how restrictive borrowing costs have become after accounting for changes in prices. Those yields have risen sharply even though the Fed has kept its benchmark rate at 3.50% to 3.75%, effectively imposing tighter financial conditions without requiring Fed Chair Kevin Warsh and his colleagues to vote for another increase. Warsh acknowledged after the July meeting that markets had already done “quite a bit.”
That initially gave the Fed room to wait. Three policymakers preferred a quarter-point increase in July, but the committee held steady while it tried to determine whether renewed inflation pressure would remain concentrated around energy and other supply shocks or spread more broadly through the economy. The bond market bought policymakers time by raising the cost of money on its own.
Now that same mechanism is creating a different message. Long-term yields have continued climbing while inflation has remained above the Fed’s 2% objective, and the 30-year Treasury has reached levels not seen since 2007. Instead of interpreting the Fed’s patience as reassuring, bond investors are demanding still more compensation for inflation, fiscal risk and the uncertainty surrounding future monetary policy.
That is where the dare comes in. Raising the federal funds rate would make borrowing more expensive immediately, but it could also demonstrate that the Fed is unwilling to tolerate another persistent inflation episode. Holding indefinitely risks leaving the bond market to impose its own version of monetary restraint, with long-term rates rising regardless of what policymakers do at the short end.
The tension is particularly uncomfortable because the economic case for a hike isn’t clean. The labor market has cooled, recent economic data have softened and much of the latest inflation pressure originated with the Middle East energy shock rather than an overheating domestic economy. Schwab’s midyear outlook still expects an extended Fed pause, while acknowledging that markets have moved from pricing rate cuts earlier this year toward the possibility of a hike.
The Fed therefore faces a choice between two kinds of restraint. It can raise the rate it controls and risk tightening into a slowing economy, or continue watching the bond market raise the rates it doesn’t directly control.
Warsh has been comfortable saying markets can do some of the Fed’s work. At 5%-plus long-term Treasury yields, bond investors appear increasingly interested in finding out whether the Fed is willing to do some of it itself.
