Despite the highest Federal Reserve policy rates in two decades, the US economy grew about 2.5% last year, unemployment remains low, and stocks are near all-time highs, leading many observers to conclude that the economy must have become less interest-rate sensitive — and probably needs permanently high benchmark rates to prevent overheating.
Consider the monumental shift in attitudes in recent months. For the better part of a decade, market economists have generally believed that the longer-run “neutral” Fed policy rate — consistent with low inflation and sustainable growth — was around 2.5%, and that remained the case even after inflation surged in 2021 and 2022. Once inflation had been beaten, economists assumed that policy rates would eventually “normalise” around that 2.5% level. But in 2023, something snapped and economists’ median views drifted up.
As of the latest survey of primary dealers conducted by the Federal Reserve Bank of New York, the median respondent now sees rates settling at around 3% — a tectonic shift in central bank forecasting. In options markets, traders are wagering on rates of around 4% into at least 2026. Market participants do not think rates will stay at their current extremes for longer than anticipated; they now also believe that rates may have to stay moderately high forever — a shift that implies far-reaching consequences for housing affordability, corporate finance and the national debt.
But with all the moving parts in the economy today, can economists know how interest rates will shake out that far in the future? I would argue that many of these projections miss the particular and fast-changing circumstances of the current moment.
Any explanation of the muted impact of rate hikes has to start with longer-term Treasuries. The 10-year Treasury yield drives the most important consumer and corporate borrowing costs, not the fed funds rate, and it has not tightened nearly as much as the latter — a historical rarity.
From March 2022 to July 2023, the Fed raised policy rates by 525 basis points, but 10-year yields increased by just 172 basis points. Even counting from the lows in 2020 to the highs in 2023, the 10-year only covered 448 basis points of territory. For most of the hiking cycle, investors and traders have been looking six months ahead to expected rate cuts that never seemed to materialise. At first, those expectations were driven by recession forecasts, and, later, by the belief in an imminent soft landing.
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However, policy rates and 10-year yields are unlikely to remain inverted forever. On the contrary, if inflation abates painlessly and the Fed cuts rates, you would expect — all else equal — the yield curve to normalise and 10-year yields to fall less than the policy rate. Just as longer-run yields have been less restrictive than expected during the tightening, they could be slightly more restrictive than you might expect during the easing. We have no reason to conclude that the transmission mechanism has broken down; the timing may have changed.
The second key issue is the “lock-in effect”. During the pandemic, consumers and businesses alike locked in ultra-low fixed-rate borrowing costs, effectively shielding themselves from higher rates. Fixed-rate borrowing has long been a feature of the US economy, but the past four years were different because of the breakneck speed at which the economy shifted gears from a fast and deep recession in 2020 to an inflationary expansion in 2021. The effect will not last forever. Already, businesses are rolling over debt at higher rates, and the effective mortgage rate on outstanding residential loans is creeping higher.
The slow process by which that is happening may well be a reason for policymakers to hold rates at the current level for a while, but this dynamic is not permanent and is unlikely to repeat itself in future tightening cycles.
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That is why I’m not on board with the near-universal adoption of the “higher rates forever” thesis. As of the latest primary dealer survey, even the bottom 25% of the economist distribution now see the longer-run neutral policy rate drifting up to 2.75%. In the SOFR (Secured Overnight Financing Rate) options market, current pricing implies just about a 30% probability of the SOFR getting back to around 3% or lower by 2026. Given what we know today, those odds strike me as a bit off balance.
We have just gone through an extraordinarily unique period in world history, and the economy is behaving in bizarre ways — but probably just for the time being. It is always worth treading carefully when folks tell you the world has changed forever. — Bloomberg Opinion
