Why Are Bond Yields Soaring?
This week, bond yields rose above 5.6% for the first time since 2002. We asked Professor William English, a former Federal Reserve economist, what’s driving the increase and what it means for the Fed, the federal budget, and the broader economy.
Federal Reserve chair Kevin Warsh at a news conference after the Fed raised interest rates earlier this month.
Bond yields have risen sharply in recent weeks. What is driving the increase?
Long-term interest rates can be thought of as the sum of two components. First, long-term rates should be broadly similar to the average level of short-term rates expected over the life of the bond. This is the case since investors can choose to either invest in a long-term bond or roll over a series of short-term investments, so their investment decisions keep the expected returns on those two investment strategies fairly close together. That said, the second component of long-term rates is a risk premium, since the outcome from the two investment strategies will differ and investors will demand compensation for the resulting risk.
Financial economists use models to estimate these two components. Those models suggest that the run-up in longer-term interest rates in recent months mostly reflects a rise in expected future short-term rates, though there has likely also been some widening in risk premiums. The increase in expected future short-term rates presumably owes to expectations of tighter Federal Reserve monetary policy in response to the stubbornly high inflation we have seen this year, as well as the surge in investment related to AI. Risk premiums may also have risen because of investors’ concerns that even tighter monetary policy for an even longer period may be needed to get inflation back to the Fed’s 2% target.
The president has been demanding lower interest rates, while the bond market is pushing in the opposite direction. What role did the bond market play in the Fed’s decision to raise rates this month?
Financial market prices can give the Fed signals about where investors think the economy is going, and those signals can be helpful in setting monetary policy. That said, the Fed may or may not agree with the market signals, depending on policymakers’ own assessments of the data and the monetary policy that they believe is called for to foster the Fed’s objectives. Monetary policy should reflect those assessments, and a blind response to market signals is unlikely to lead to better policy outcomes.
And, of course, the Fed should not allow short-term political considerations to affect its policy choices—Fed policy should depend on expert judgment regarding what policies are likely to provide the best outcomes for the American people.
If long-term bond yields remain at these levels, what does that mean for the broader economy—for mortgages, business investment, government borrowing, and economic growth?
The current interest-rate level is unlikely to cause the economy to slump, since an important reason for the tighter monetary policy is a desire to avoid having the anticipated extraordinary levels of AI-related investment cause the economy to overheat. However, higher longer-term interest rates may damp activity in other sectors. Higher mortgage rates will likely slow residential construction activity, high auto loan rates could damp spending on cars, and business investment unrelated to AI may also slow somewhat because of increased borrowing costs. This sort of rebalancing across sectors is to be expected when there is a sharp increase in spending in a particular sector, like the one we are seeing today in AI.
The current elevated interest rates will also put additional stress on the federal budget as past borrowing is rolled over at higher rates. Federal outlays for interest payments were roughly 1.5% of GDP until 2021, but they more than doubled by 2025 as deficits accumulated and interest rates rose. Higher interest rates are boosting them further this year.
The fundamental problem is that fiscal policy in the United States in on an unsustainable path, and at some stage Congress and the administration will have to raise taxes or cut spending to move us back onto a sustainable path. Those decisions will be difficult, of course, but the Fed should not make changes to monetary policy with the aim of helping with the needed fiscal adjustment. The Fed has its monetary policy job—fostering maximum employment and stable prices—and the fiscal authorities have theirs.