- Some on Wall Street claim the central bank went too far
- Fed’s defenders point to stability of inflation expectations
When Federal Reserve officials gather in two weeks they’re likely to ponder a puzzling trend in markets: Since September, as they lowered short-term interest rates by a full percentage point, longer-term government bond yields moved by a roughly equal amount — but in the opposite direction.
Fed rate cuts are supposed to lower borrowing costs for everyday Americans, which should bolster the economy. Higher 10-year Treasury yields mean the opposite has happened, making it more expensive for many families and businesses to borrow.
To some on Wall Street, the mismatch is evidence the US central bank misread the economy and went too far with rate cuts.
“There’s no way the data suggested the Fed should be cutting rates” in December, said Joseph Lavorgna, chief economist at SMBC Nikko Securities, who sent a note to clients on Dec. 23 entitled: “The Fed Caused the Bond Market Sell-Off.”
Lavorgna isn’t alone in his view, but a bevy of economists, analysts and former Fed officials disagree. The rise in yields, they say, stems more from the unpredictability of the incoming Trump administration, worries about the economic outlook and concerns about swelling deficits.
“The Fed and the markets are both dealing with a great deal of uncertainty,” said Don Kohn, a senior fellow at the Brookings Institution and a former Fed vice chair. “So people are asking for more compensation for holding these longer-term securities.”
By any explanation, the numbers are striking. On Jan. 14, the yield on the 10-year Treasury note reached 4.81%, its highest since November 2023, and about 1.1 percentage point higher than when the Fed started cutting on Sept. 18. It has dropped back to around 4.6% since December inflation data came in tame on Jan. 15.
A number of economists agreed it would be worrying if higher bond yields meant investors had lost confidence in the Fed’s ability to bring inflation fully under control. New rate cuts would be off the table, and officials may even have to consider backtracking.
But if that were the case, said Matthew Luzzetti, chief US economist at Deutsche Bank AG, it would show up in market-based inflation expectations. Yet those measures — such as the difference between the yields on ordinary Treasuries and inflation-protected Treasuries, known as breakevens — are not far from where they were in the first half of last year, he said.
New York Fed President John Williams made the same point to reporters on Jan. 15. Instead, he said, the rise in yields is probably a “reflection both of the strength of the incoming data but also markets’ uncertainty about issues of fiscal policy, other policies, global developments more generally.”
No policymakers have indicated the Fed needs to alter their playbook for the coming year because of rising yields. Williams and many other officials continue to say they will support lowering rates again once inflation shows more progress in moving down toward their 2% target.
Luzzetti, meanwhile, offered another possible explanation for rising yields: It could be a sign investors think the so-called neutral rate — or the level at which the Fed’s benchmark would neither slow nor juice the economy — is now higher.
Policymakers have been debating whether neutral has been driven higher by recent improvements in productivity. If that proves true, that means the Fed will finish its cutting cycle at a higher level than previously expected. But few believe they’ve already reached or gone below neutral.
Officials have steadily ticked up their own estimates for where rates will ultimately settle. Their mean projection in December was 3%, up from 2.5% a year earlier. That’s still well below the 4.25%-4.5% target range for the federal funds rate.
Surprising Data
Other Fed defenders argue that policymakers have merely been responding to unusually volatile data.
When officials began lowering rates in September, they opted for a half-point cut out of deep concern the labor market was on the brink of a sharp downturn. Since then, it’s shown surprising strength while the decline in inflation has stalled. The Fed responded by delivering two smaller, quarter-point drops before signaling they may only lower rates by a half point in all of 2025.
“The data has come in stronger and inflation has been stickier than everyone expected, including the Fed,” said Bill Nelson, chief economist at the Bank Policy Institute and a former Fed economist. “That doesn’t mean they made a mistake. That doesn’t mean they made an incorrect move given the data at hand. It just means the data has been surprising.”
SMBC Nikko’s Lavorgna isn’t as sympathetic.
He said he understood the big move in September because of the worries that joblessness might rise substantially. But, he said, the Fed should have pivoted sooner and held rates steady when data showed the labor market stabilizing.
Tracy Chen, a portfolio manager at Brandywine Global Investment Management, also is convinced the Fed should have held steady in December.
“The economy has remained very resilient,” Chen said. “There remains a possibility that inflation could re-accelerate sometime again. Yields may have not peaked yet either.”
Policy Lags
Mistake or not, policymakers should be careful to explain that a number of factors could be causing yields to rise, said William English, a professor at the Yale School of Management and a former division director at the Fed’s Board of Governors.
It’s also important, he said, to point out that monetary policy works with lags, and officials are working to position policy based on where they think the economy is headed. With officials expecting growth to slow and inflation to gradually reach its 2% target, they can’t wait until those trends fully play out before adjusting rates, he said.
“They want to get policy on a trajectory to deliver the outcomes that they’re looking for,” said English. “Whether the December move will look like a mistake depends on where the economy ends up, and we don’t really know.”
Written by: Jonnelle Marte — With assistance from Reade Pickert and Liz Capo McCormick @Bloomberg
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