I'm LongbridgeAI, I can summarize articles.Global bond yields are hitting multiyear highs, prompting the Federal Reserve to decide if the era of low interest rates is over. Policymakers face tension between viewing high rates as temporary shocks from supply chains and geopolitics versus a structural shift driven by AI capital demand and persistent inflation. With markets pricing in a likely rate hike at the upcoming meeting, the Fed must determine if this represents a return to pre-crisis norms or a new regime requiring sustained higher policy rates.
By Craig Torres, James Clouse and Fabio Natalucci
High bond yields could be the result of temporary shocks - or something much longer-lasting
Federal Reserve Chairman Kevin Warsh on screen at the G-20 meeting in August. Going into the Fed's meeting this week, there was an emerging tension among policymakers.
Global bond yields are touching multiyear highs, and as the Federal Reserve meets to set interest-rate policy this week, officials will have to discuss whether this is repricing back into ranges last seen before the 2007-08 financial crisis, or a structural turn in the global economy that will require higher interest rates for years to come.
On the one hand, the high rates may be the result of temporary supply-chain frictions and energy insecurity. But real interest rates, or the return on money apart from inflation compensation, have also moved up and may remain higher as demands for capital increase with the artificial-intelligence boom and possibly higher productivity, indicating a more structural change.
Going into the meeting, there was an emerging tension among policymakers. There are those who have resisted raising rates on an expectation that the Iran war's energy shock and the effect of tariffs will eventually subside, leaving inflation back on a path toward the Fed's 2% target. There are others who say a world of rolling supply shocks amid geopolitical tensions is creating inflation persistence that won't go away without higher policy rates.
While the Fed has held rates steady this year, the European Central Bank, the Reserve Bank of Australia and the Bank of Japan have all pushed their policy rates higher.
But there are signs the Fed may be changing that approach. New Chairman Kevin Warsh has become more pointed about inflation. He warned in his remarks at the Jackson Hole central-bank symposium that "we have work to do" if inflation doesn't start moving toward the 2% target.
The consumer-price index rose 3.4% for the year ending August, and traders are now pricing in about a 94% probability of a quarter-point hike at the Sept. 15-16 Fed policy meeting, as well as one more by the end of the year.
A historical blip of low rates
For nearly a dozen years, starting with the global financial crisis and rolling into the pandemic through mid-2023, 10-year U.S. Treasury yields BX:TMUBMUSD10Y were below 4%. Total assets held by the Fed expanded to $7.7 trillion by the end of 2023, from $871 billion at the end of 2006, partly due to trillions of dollars in Fed Treasury bond purchases through market stabilization and quantitative-easing programs.
Taking medium- and longer-term Treasurys out of the market helped pull longer-term interest rates down by lowering the extra compensation required by investors to hold such securities. The Fed also cut and held its policy rate at zero for seven years following the financial crisis, and for two years during the pandemic.
Inflation measured by the Fed's preferred target, the personal-consumption expenditures (PCE) price index, averaged just 1.4% from 2009 to 2019 as the U.S. economy slogged along with sluggish job growth.
That phase is starting to look like a historical anomaly.
U.S. 10-year yields are now back in ranges seen before the global financial crisis, partly because both inflation and real interest rates are higher. PCE inflation rose 3.7% for the year ending July. The yield on the U.S. 10-year note apart from inflation compensation is around 2.6%, the highest since the global financial crisis.
One way to consider today's higher rates is as a "return to normal" after the crisis pothole.
Renormalization is a bet that rates won't go much higher from here
There's evidence for this view. Demand for capital is high because of the artificial-intelligence build-out, which could boost U.S. productivity in years ahead. That requires higher interest rates to pull savings in. Private-sector capital needs are competing with the government's own need for funds at longer maturities. Years of undisciplined fiscal policy have doubled the debt-to-GDP ratio over the past two decades to over 100% in the U.S.
The case for a renormalization of rates after the pothole is a bet that rates don't go much higher from here as shocks subside and government policies are eventually oriented toward a convincing plan to bring the deficit and inflation down.
Looking at prices in markets, the 10-year Treasury currently yields around 5%. Real yields on 10-year TIPS securities are about 2.6%. The difference between these two yields is a market-based measure of inflation compensation of 2.4% plus an inflation risk premium. Adjusted for the usual gap between CPI inflation and PCE inflation, that suggests investors anticipate average expected inflation to be close to the Fed's 2% target over the next 10 years.
Regime change may already be taking place
Forward markets, however, hint that a regime change is taking place - one where rates will need to be higher to achieve the Fed's inflation target. Real one-year yields, a proxy for the real policy rate, nine years from now are at 3.3%, higher than just before the global financial crisis.
Of course, uncertainty is large around any prediction. There is no near-term resolution for either the Iran or Ukraine wars, and in the U.S., new rounds of tariffs and trade wars continue to flare up. There is no real fiscal-stability plan.
Forecasts from the Fed would benefit from scenarios that encompass the possibility that interest rates are signaling something more structural and lasting than a series of temporary shocks.
It is hard to predict a return to the old normal amid continued geopolitical instability, trade and hot wars, and a more economically interventionist government. Antiglobalization nationalists are also ascendent in other developed economies.
While no central banker wants to commit to a rate path amid huge macro and geopolitical uncertainties, any discussion of what it will take to get inflation back to target must include the possibility of a regime-change scenario.
That foresees a world of disrupted trade through tariffs and conflicts over chokepoints, more costly onshoring and less immigration, while political systems test the limits of spending to fund their militaries.
The outlines of this scenario are already visible, and the risk is inflation is higher and more persistent than expected. With inflation above target for more than five years in the U.S., it is looking increasingly necessary to run more restrictive policy to return inflation to the Fed's 2% goal - even if the AI boom may deliver, at some point in the future, the productivity boost we all hope for.
Craig Torres is editor in chief, James Clouse is a senior fellow and Fabio Natalucci is CEO at at the Andersen Institute for Finance and Economics.
-Craig Torres -James Clouse -Fabio Natalucci
This content was created by MarketWatch, which is operated by Dow Jones & Co. MarketWatch is published independently from Dow Jones Newswires and The Wall Street Journal.