Bond market spooks the Fed

The Federal Open Market Committee (FOMC or Fed) left its key policy rate unchanged following its meeting today, as most market watchers expected. Although there were some reasons for the Fed to raise rates, the main argument against a hike was the sharp rise in bond yields since the last FOMC meeting in September. Higher long-term yields discourage borrowing and spending in much the same way that increases in the Fed's short-term policy rate do, so the bond market is effectively doing the Fed's job of cooling off the economy to bring inflation back down to target. Indeed, if bond yields stay this high or go higher, the risk of a recession next year will rise.

At the September meeting, two-thirds of FOMC participants indicated that they expected to raise rates one more time in 2023, while one-third said they were probably done raising rates. Since then, economic growth has been surprisingly strong and inflation only gradually declining from last year's highs. But the biggest news has been the sharp rise in long-term bond yields. The yield on 10-year Treasury notes is about 0.5 percentage point higher than at the time of the last FOMC meeting.

The economic impact of higher bond yields depends on what is driving them higher. If higher yields reflect higher expected inflation or a surge in future productivity growth, they will have little harmful impact on economic growth. However, the recent runup in yields does not appear to be driven by such factors and instead reflects a higher term premium, possibly caused by investor concerns over congressional gridlock in the face of rising fiscal deficits. Higher term premiums do reduce borrowing and spending and thus reduce economic growth. According to one estimate, the increase in Treasury yields in recent weeks may have the same effect as four Fed rate hikes of 0.25 percentage point each.