Fed meeting preview: Will surging bond yields force the Fed to pause its interest rate hikes?

The Federal Reserve hasn’t raised interest rates since July. That hasn’t stopped borrowing costs from continuing to wallop consumers.

The 30-year fixed-rate mortgage has surged more than a percentage point since officials on the Federal Open Market Committee (FOMC) last voted to increase borrowing costs. More than half of that increase has occurred since the Fed’s September meeting alone — even despite the Fed hitting the pause button that month.

Mortgages have joined a list of other surging consumer loans in recent weeks, from credit cards and home equity lines of credit to auto loans and personal loan rates.

The extra pressure is coming from somewhere important: A massive rout in the U.S. Treasury market. The 10-year Treasury yield has surged this month, hitting the highest level in 16 years and even briefly breaking 5 percent. The key rate is another important benchmark, influencing the longer-term debt that the Fed doesn’t directly control. It’s only adding to the overall tightening in financial conditions that began when the Fed first started raising rates.

To be sure, higher interest rates are what the Fed wants. Since March 2022, officials have been rushing to cool the hottest period of inflation since the 1980s. They’ve approved 11 total increases worth a massive 525 basis points — the fastest series of rate hikes in four decades.

But the speed at which longer-term rates have been surging could give the Fed pause — especially if it’s a sign that their rapid rate hikes are finally making their way through the economy.

Economists say the Fed will likely leave interest rates alone when its next rate-setting meeting concludes on Nov. 1, so Fed Chair Jerome Powell & Co. can keep assessing the economic backdrop. Here are the three biggest economic questions facing Fed officials ahead of their next meeting — and beyond.

1. Will surging bond yields keep the Fed on the sidelines indefinitely?

There’s an elephant in the room at the Fed’s upcoming meeting: Policymakers signaled in September that they were planning to raise interest rates one more time this year. If borrowing costs across the market keep climbing on their own, however, they might not have to.

From Vice Chair Philip Jefferson to Dallas Fed President Lorie Logan, many Fed officials are already starting to hint that the tightening in bond yields could do the Fed’s work for it. Powell himself said in remarks on Oct. 19 that higher yields could reduce “at the margin” the need for the Fed to raise rates again.

San Francisco Fed President Mary Daly called the recent run-up in bond yields — amounting to about 36 basis points at the time — the equivalent of “about a rate hike” back in an Oct. 5 interview with Bloomberg. Treasury yields have climbed another 23 basis points since then.

“If financial conditions are sufficiently tight, our work is not necessary,” Daly told Bloomberg Television, referring to the extra rate hike officials penciled in back in September.

Simply put, investors sway long-term bond yields, which rise when demand for those assets falls. The challenge, however, is determining what’s causing the surge, and some reasons could be better news to the Fed than others.

Economists cite concerns about massive government deficits and new debt issuance as one reason why investors may be hesitant to hold onto longer-dated bonds. The largest buyer in the marketplace — the Fed itself — has also stepped away as it continues shrinking its balance sheet.

Satisfying policymakers, investors could also be starting to take the Fed’s word when it says it plans to keep borrowing costs higher for longer.

When longer-term interest rates don’t move in the same direction as the Fed’s key short-term rate, it makes the U.S. central bank’s job harder. Treasury bonds dipped in the summer of 2022, as investors doubted that the Fed would be able to push borrowing costs as high as they were promising. It loosened financial conditions enough to scare Powell into putting his foot down in an aggressively hawkish speech at the U.S. central bank’s August 2022 Jackson Hole Symposium. He promised to “keep at” the Fed’s inflation fight until the job was done, even if it meant causing “a sustained period” of lower growth painful for businesses and households.

Investors quickly took note. The 10-year Treasury surged more than 1.5 percentage points between July and October, lifting the 30-year fixed-rate mortgage to 7.12 percent. That was the highest of the post-pandemic era — until mortgage rates topped 8 percent for the first time since 2000 on Oct. 25, according to a Bankrate rate survey.

“The Fed does not control the long end of the curve, so it’s not uncommon for one to zig while the other zags,” McBride says. “The rise in Treasury yields drives up borrowing costs across the board. If the government is going to pay more, so is everybody else.”

2. Just how strong is the U.S. economy?

A worrisome reasoning for bonds surging, however, could be investors expecting a resilient economy and stubborn inflation. Expectations that price pressures will keep rising are often a self-fulfilling prophecy.

“We have to let this play out and watch it, but for now, it is clearly a tightening in financial conditions,” Powell said.

The U.S. economy grew 4.9 percent in the third quarter, the strongest pace since 2021, driven by a resilient and eager-to-spend consumer. Employers in September also added 336,000 jobs, the most in eight months and a pace that blew past expectations. It underscores just how resilient the labor market has remained, defying the odds of a more material slowdown.

“If the Fed hadn’t seen this adjustment in interest rates, at the very least, it would be a close call,” says James McCann, deputy chief economist at abrdn. “Higher interest rates will make them nervous because they’re aiming to pull off a soft landing. The more tightening in financial conditions, the harder that becomes.”

Fed officials aren’t anywhere close to saying they’ve finished wrestling inflation. Prices aren’t rising at as quick of a pace as they were just last summer, but lately, they’ve been heading sideways instead of decreasing. Consumer prices lingered at a 3.7 percent annual growth rate in September, matching the same level from August and hovering above a post-pandemic low in June of 3 percent.

Core inflation — which can be less noisy because it excludes volatile food and energy prices — is largely seen as the ultimate signal of where prices are heading. That measure is still up 4.1 percent from a year ago, two times as high as the Fed’s target. Yet, it’s a whopping 2.3 percentage points lower than it was at the beginning of the year, a step in the right direction.

Longer-term rates matter for the Fed’s job because of how powerful of an interest rate benchmark they are for the financial system. It’s not just relevant for prospective homebuyers or consumers, but companies, cities and other governments around the world who turn to financial markets for credit.

“That’s the brake pedal that the Fed is trying to apply to the economy,” says Luke Tilley, chief economist at Wilmington Trust Investment Advisors. “Not the overnight funds rate.”

Once longer-term rates finally take heed of the message, it might be the point when the U.S. economy can’t keep standing its ground against the highest borrowing costs in decades.

Meanwhile, consumers have been drawing down on their pandemic-related savings, their incomes have slumped in the face of inflation and student loan payments are also taking more cash out of their pocketbooks. Economists say the post-pandemic economy has been exceedingly tough to predict, but those headwinds could make the U.S. economy’s blockbuster third-quarter performance short-lived.

“Those dynamics have a shelf life,” McCann says. “The stakes for the Fed probably feel a little bit higher. There’s a risk now that they overtighten and end up killing the economy unnecessarily.”

3. What will need to happen to bring inflation down to 2% once and for all?

The ultimate question for the Fed is whether it needs to raise rates more to see the progress it wants on inflation — or whether it just needs to keep rates at that historically high level for longer. The latter may have the biggest impact on consumers.

“Another rate hike is not going to have that big of an impact,” Tilley says. “What is going to have more of an impact is the discussion of how long do we keep them at this level.”

Rate hikes travel through the world’s largest economy a bit like how a rocket ship hurtles through the vast void of outer space: It takes a while for them to reach their destination.

Except the U.S. central bank isn’t aboard the USS Enterprise. Fed Chair Jerome Powell & Co. are flying blind. Data is backward-looking. It’s constantly updated and revised. Not to mention, bouncing between record-low and decades-high rate eras so quickly may have disrupted monetary policy’s flow through the financial system.

Homeowners and business owners refinanced when longer-term financing rates slumped, freeing up cash that they’ve now been relying on to handle inflated prices. Consumers, meanwhile, delayed spending on experiences and appeared willing to blow cash this summer on concerts, travel and sporting events.

For the Fed, deciding what to do with interest rates when borrowing costs are the highest since 2001 and inflation remains stubborn isn’t as simple or as clear-cut as forming a game plan when inflation was breaching 9 percent and borrowing costs were near record lows.

Economists in Bankrate’s third-quarter Economic Indicator poll are also questioning whether Powell & Co. need to push harder on the job market to get inflation back to 2 percent. Inflation has already been cut in more than half without a material dent in unemployment and hiring, they say. Meanwhile, the job market was tight in the pre-pandemic era without leading to more inflation.

A hot job market can lead to inflation if businesses have to raise wages and lure workers. But allowing the job market to continue chugging along in this case may even have some inflation-improving benefits, according to Tilley.

He points out that the labor force has grown by roughly 3 million workers since the start of the year alone, Labor Department data shows. The number of prime-age workers — those between the ages of 25 and 54 — in the labor force has also surged past pre-pandemic levels.

“It’s perfectly fine to have strong job growth if you’ve got the supply of workers coming on,” Tilley says. “Restaurants are getting more workers, and now they can reopen that section they had closed. Hotels can flip rooms faster. Businesses can catch up with the demand; therefore, they don’t have to keep pushing through price increases.”

Bottom line

The Fed will eventually have to debate just how long “higher for longer” will need to last, but officials aren’t there yet. High interest rates likely aren’t going anywhere anytime soon. The best steps consumers can take involve paying down high-interest rate debt, keeping on track with your retirement contributions and building up your emergency fund.

The U.S. economy may look strong on paper right now. But just because a recession hasn’t materialized yet, doesn’t mean one won’t at all.

“Looking out the rearview mirror is not the same as looking out the windshield,” McBride says. “In an environment where the money supply is contracting, where policy is getting tighter and tighter, the economy will slow, even if we haven’t seen it to this point. It can come on and come on in a hurry. I think that’s very likely in 2024.”