Why the Fed vigorously backpedaled on further rate cuts and pivoted to wait-and-see: Long-term interest rates matter.
By Wolf Richter for WOLF STREET.
Fed Chair Powell, at his testimony before the Senate Committee on Banking, Housing, and Urban Affairs today, included his nearly standard line about longer-term inflation expectations being “well anchored, as reflected in a broad range of surveys of households, businesses, and forecasters, as well as measures from financial markets.” The first three are survey-based – what households, businesses, and forecasters see coming at them. The last is based on trading results in the Treasury market, what the Treasury market sees coming at it. It’s the bond market talking here, and the bond market is getting worried again about inflation.
The 5-year breakeven inflation rate rose to 2.64% today, the highest since March 2023, having shot up by 78 basis points since just before the Fed’s September rate cut. This measure (5-year Treasury yield minus the 5-year Treasury Inflation Indexed Real Yield) shows what the bond market saw today as the average inflation rate over the next five years.
The Fed has cut by 100 basis points, while this measure of market-based inflation expectations for average inflation over the next five years has shot up by 78 basis points. It has become “unanchored,” as one might say to needle Powell during the FOMC press conference:
A Fed that is lax about inflation scares the bond market once inflation starts rumbling. And the Fed has seen that reaction from the bond market too – including the surge of longer-term yields, such as the 10-year Treasury yield, since the beginning of the rate cuts – which is why it has walked back any talk of further rate cuts and instead has pivoted into wait-and-see mode to not unnerve the bond market further.
The 10-year breakeven inflation rate (10-year Treasury yield minus the 10-year Treasury Inflation Indexed Real Yield) is a little more sanguine but is also coming unanchored. This measure of what the bond market saw today as the average inflation rate over the next 10 years rose to 2.46%, the highest since October 19, 2023, and before that day the highest since March 2023. It shot up by 44 basis points since just before the Fed’s September rate cut.
The rate cuts unnerved the bond market. The bond market saw that inflation wasn’t quite done with yet when the Fed was cutting rates just as inflation was starting to re-accelerate. This infused the bond market – and not just the bond market – with concerns that the Fed would be more tolerant about inflation going forward, along with signs of fear that inflation would on average be higher over the next five years in particular.
This jump in inflation expectations by the markets, along with the surge of the 10-year yield following the rate cuts, likely triggered the energetic backpedaling by the Fed on further rate cuts. It is now in official wait-and-see mode. Powell and the other Fed governors now keep hammering home the point that they can be “patient” with their rate cuts.
The bias today is still for cuts, not hikes. Inflation would have to make larger and more sustained moves higher for the Fed to switch the bias to rate hikes.
But a bond market freakout over accelerating inflation and a lax Fed – resulting in higher long-term yields that really matter for the economy – would nudge the Fed to switch its bias to rate hikes again. To keep long-term yields from rising too much, the Fed will need to show the bond market that it’s serious about inflation, and that it will crack down again if inflation re-accelerates substantially.
That’s the irony: The Fed might have to hike short-term rates again to make sure long-term interest rates remain “moderate” – paying attention to the third part of its mandate, to conduct monetary policy “so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” The mandate is silent about the Fed’s short-term policy rates. It’s “long-term interest rates” that are in the mandate, and the way to get there is to keep inflation in check.
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Thank you for another clear explanation of what is happining currently with the bond market and the Fed.
“To keep long-term yields from rising too much, the Fed will need to show the bond market that it’s serious about inflation”
I wish there were a way to send this article to Powell.
He said that today and before. Hence the wait-and-see.
But what does serious about inflation look like?
Wait & see, rate cuts, rate hikes???
Wait & see sounds like “transitory”
Rate cuts sound just as crazy today as they did back in Nov & Dec
Rate hikes is where the bond market expects this to go, so how long does wait & see take?
Nothing the Fed has done since last Sept has made any sense.
All inflation measures are still a LOT lower than the Fed’s policy rates. There is no reason for the Fed to hike now. Inflation rates can rise by a full percentage point, and they’d still be below the Fed’s policy rates. The Fed is at 4.33%! CPI yoy = 2.9%. What’s your problem?
Some of us just like the chaos and spectacle, I think. Writing comments on blogs demanding the Fed hike rates has its own jouissance.
Dear Wolf….help me understand this please
If the saving rate (public plus private) is less than the deficit then shouldn’t the long term interest rate go up (or remain high).
Unless of course the world is generous enough to fund our deficits are low rates.
So assuming there is 2% (current) inflation but the world doesn’t fund our expenses then long term interest rates should still remain high.
Would that be reasonable to think? Or are there more variables at play.
The market drives long-term interest rates, not any particular equation or savings rate or whatever. The market consists of supply and demand. There is a LOT of supply from the deficit spending, but there is also a lot of demand from the US and globally, which is why the 10-year yield is only 4.5% and not 6%. Yield makes sure that there is always enough demand, that’s the job of yield, that’s what it does. If inflation is seen as higher in the future, demand will take that into account and will materialize only at a high enough a yield so these buyers are compensated for their inflation expectations, and so higher inflation expectations translate eventually into higher yields.
Gold near to $3,000/ounce. Pennies being taken out of circulation. Mtg rates up. Inflation doesn’t look like it’s going anywhere but up. Waiting for the bond vigilantees to come out of the woodwork.
It seems like a mistake to have lowered rates by so much over a short period of time. But who am I ??
Survey based expectations haven’t exactly been “well anchored” lately either.
1-year UofMich expectations have spiked +1.7% since the rate cut.
And, as far as I can tell, the 5-year UofMich expectations have hit a 30-year high (excepting maybe a month or two in 2008)
But the UofMich survey just shows the political divide in the US, with Republican-leaning respondents seeing very little inflation and Democrat-leaning respondents seeing red-hot inflation. This totally flipped after the election. Before the election, it was the opposite. In the data, look at the political divisions of it. Just funny.
The New York Fed’s survey of inflation expectations yesterday wasn’t particularly hot (3.0% for 3 years, unchanged from prior month)
Hard to envision any near or medium term situation where the demand for treasuries will go down enough to make long term yields rise significantly. Any event that might cause that would likely not be isolated to the US. Our political system also makes all of this impossible to predict given the pendulum nature where the only constant is lots of spending. The Fed is really just reactionary to the political machine.
There was no landing, soft or hard. So, rates are fine unless you are long on housing, hoping for personal wage inflation, or long on BTC/Big Tech.
Bitcoin is bound to rise just like gold. It is only trading as a “risk asset” because people don’t understand it. It’s an entropic store of value. You burn energy mining Satoshis and have cryptographic guarantees for that work done. It is symbiotic with our AI future.
“On balance, the influence of the Federal Reserve System in its early decades served to lower interest rates below what they otherwise would have been, both in periods of falling and in periods of rising interest rates.” —Sydney Homer and Richard Sylla, A History of Interest Rates
It was true in the “early decades,” as Homer and Sylla saw it. Is the bond market beginning to sense that it’s equally true now?
We can be assured that whatever the fed does, it will be late, early, or just wrong!
We can be assured that Washington will not agree on anything and the hot air will increase global warming.
I could surely be wrong, but everything I see, points to inflation.
Wait, see, and pass the pop corn.
“We can be assured that whatever the fed does, it will be late, early, or just wrong!”
That just depends on where you stand. If you’re in real estate, the Fed was wrong hiking rates and keeping them high. It should have kept 0%. If you like T-bills, the Fed was wrong cutting rates.