Investors are betting that the Federal Reserve, which has raised interest rates to their highest level in 22 years, may finally be on its last legs.
Several senior Fed officials have suggested in recent days that the central bank’s efforts to cool the economy through higher borrowing costs are being boosted by recent market moves that are essentially doing some of that work for them.
Attention has particularly focused on a rise in U.S. Treasury interest rates, with the 10-year Treasury yield briefly hitting a two-decade high last week. This yield is incredibly important because it acts as the foundation of the market, supports interest rates on many other types of loans, from mortgages to corporate bonds, and influences the value of companies on the stock market.
Philip N. Jefferson, the Fed’s vice chair, said this week that while it is “perhaps too early to say with confidence that we have tightened monetary policy sufficiently,” higher market interest rates will reduce spending by businesses and households could depress share prices at the same time. He added that the Fed wanted to avoid doing too much and causing unnecessary damage to the economy.
With that in mind, he said the Fed “will consider developments in financial markets as well as the totality of incoming data when assessing the economic outlook.”
Investors have sharply reduced their expectations of a further interest rate hike before the end of the year. They see about a one in four chance that policymakers could raise interest rates again.
“If financial conditions tighten regardless of monetary policy expectations,” then “that will reduce economic activity,” said Michael Feroli, chief U.S. economist at JP Morgan. “Things change, you change your forecast.”
Investors had previously expected the Fed to stop raising interest rates, but that has proven wrong. There is still a chance that the market dynamics contributing to the rise in borrowing costs could reverse, and this week the recent rise in 10-year yields eased somewhat. However, if market interest rates remain high, this could add to the significant rise in borrowing costs that the Fed has already ushered in for consumers and businesses.
The Fed has raised its key interest rate from near zero to over 5.25 percent over the past 19 months to curb inflation. But the Fed directly controls only very short-term interest rates. It may take a while for the measures to take hold in the economy and impact longer-term borrowing costs – the kind that affect mortgages, business loans and other areas of credit.
There are likely several reasons why longer-term interest rates have risen sharply in the markets over the past two months. Wall Street may be waking up to the possibility that the Fed will keep borrowing costs high for an extended period of time, economic growth has been strong and some investors may be concerned about the level of national debt.
Over time, the rise in Treasury yields is likely to weigh on the economy, and Fed officials have made clear it could do some of the work of another rate hike for them.
Officials had forecast in September that they may have to raise rates again this year. But comments from Mr. Jefferson and some of the Fed’s more inflation-focused members were widely seen as a signal that the Fed was likely to be more cautious.
Christopher J. Waller, a Fed governor who has often advocated higher interest rates, said at an event on Wednesday that officials were able to “watch and see” what was happening and that they supported the move “very much.” “We would keep a close eye on it” and “how these higher interest rates impact our policy actions in the coming months.”
Lorie K. Logan, president of the Federal Reserve Bank of Dallas, said Monday that higher market yields “could do some of the cooling of the economy for us, so there is less need for further tightening of monetary policy.”
However, she noted that this depends on why interest rates rose. If they had risen because investors wanted to get more money to take on the risk of long-term bonds, the change would likely put pressure on the economy. If they had risen because investors believed the economy was capable of growing faster even with high interest rates, it would be a different story.
Even Michelle W. Bowman, a Fed governor who tends to favor higher interest rates, has softened her stance. Ms Bowman said on October 2 that further adjustment would “probably be appropriate”. But in a speech she gave on Wednesday, that wording was less clear: She said interest rates “may need to be raised further.”
The softer tone among Fed officials appears to have helped halt the rise in market interest rates, with the yield on the 10-year Treasury note down 0.2 percentage points so far this week. On Tuesday, yields fell more than ever since the turmoil caused by the banking crisis in March. This likely reflected investors fleeing to the safety of U.S. Treasury bonds following the outbreak of war in Israel and Gaza. Nevertheless, the return is still around 4.6 percent, around 0.8 percentage points higher than at the beginning of July.
“It seems like there is a little bit of unrest,” said Subadra Rajappa, head of U.S. interest rate strategy at Société Générale.
Higher interest rates also typically weigh on stock prices, as major indexes come under pressure in the summer along with the rise in yields. The S&P 500 suffered its worst month of the year in September, but is up 2 percent so far this month as yields fell.
Policymakers will get further insight into the impact of interest rate hikes with the release of the Consumer Price Index on Thursday. Economists expect the data to show a continued gradual slowdown in inflation despite the economy’s unexpected resilience.
However, that could change, especially if yields continue to fall and pressure on the economy eases somewhat.
A robust economy could maintain the possibility of another Fed rate hike, even if investors consider it unlikely. Ms Logan warned that policymakers should avoid overreacting to market moves if they fade quickly.
And Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, said Tuesday that long-term interest rates may have risen in part because investors expected more action from the Fed. Therefore, if the Fed signals that it will be less aggressive, it could back down.
“It’s hard for me to say definitively — hey, because they moved, so we don’t have to move,” Mr. Kashkari said. “I do not know yet.”
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