The Fed next meets on Oct. 31 and Nov. 1. The rebound in US inflation since the September meeting has been very clear, but inflation is no longer the primary determinant of the Fed's monetary policy.
Combined with the Fed's message, capital markets have begun to believe that a sustained rise in long-term US Treasury yields could bring the current rate hike cycle to an abrupt end.
Senior Fed officials have said in recent days that if long-term rates remain near their recent highs and inflation continues to cool, the increase in short-term rates is complete. The rise in long-term Treasury yields began after the Fed raised rates in July and accelerated after the September Fed meeting.
The yield on the 10-year Treasury note closed Tuesday at 4.654 percent, just below the previous week's high, as investors sought the safety of bonds after Hamas attacked Israel on Saturday. Still, the 10-year yield is higher than 4.346% on Sept. 20, the day of the Fed's last meeting, and 3.850% on July 26, the day the Fed last raised rates.
The Fed raised its benchmark federal funds rate in July to 5.25% to 5.5%, a 22-year high. In September, the Fed put rates on hold but said it would raise them at one of its last two meetings of the year.
The Fed raises interest rates to fight inflation by slowing economic activity, and the main transmission mechanism is through financial markets. Higher borrowing costs lead to weak investment and spending, a dynamic that is reinforced when higher interest rates also affect stock and other asset prices.
The most obvious outcome now is that a sustained climb in the 10-year Treasury yield to its highest level since 2007 could replace further increases in the Fed funds rate. The Fed initially attributed the rise in long-term interest rates to better economic news. That has prompted bond investors to reduce bets that a recession will prompt the Federal Reserve to cut interest rates in the first half of next year.
But the rise in interest rates appears increasingly driven by factors that cannot easily be explained by the outlook for the economy or Fed policy. This suggests that the so-called long-term premium, or the extra yield investors demand to invest in long-term assets, is rising.
Lorie Logan, president of the Dallas Fed and a voting member of the Fed's rate-setting committee, said on Monday: "If long-term interest rates continue to rise as a result of higher long-term premiums, then the need to raise the Federal Reserve funds rate may diminish." Logan's comments are a marked shift from Fed officials, who have been leading advocates for a rate hike this year.
The term premium on bonds is hard to measure accurately. According to Logan, at least half of the increase in long-term Treasury yields since the end of July reflects a higher long-term premium.
Fed Vice Chairman Philip Jefferson also said Monday that it will "continue to recognize tightening financial conditions through higher bond yields" when deciding whether to raise rates again this year.
Mary Daly, president of the San Francisco Fed, said last week that the rise in Treasury yields since Fed officials last met was roughly equivalent to a quarter-point rise in the Fed's short-term interest rate. "If fiscal conditions, which have tightened significantly over the past 90 days, remain tight, our need for further action will diminish," she said.
Fed officials said they would not raise rates in November, but would need to confirm how economic and financial developments were in November before deciding whether to raise rates in December.
Even after the Fed completes the rate hike, Fed officials are unlikely to formally announce a halt to rate hikes. After all, the Fed has repeatedly been surprised by the economy's resilience and has been more willing to leave the door open for further rate hikes.
By December, the Fed will be able to see whether the recent tightening in financial conditions has persisted and whether the recent progress on inflation has continued. Some officials may be less concerned that strong economic activity, such as surprisingly strong hiring, could keep inflation from falling if higher long-term interest rates persist.
Brij Khurana, a fixed income portfolio manager at Boston-based Wellington Management, said Fed officials have reason to be frustrated because aggressive rate hikes have only modestly pushed up long-term yields. That's partly because investors expect higher rates to cause a recession and lead to lower rates.
Asset managers say the rise in long-term bond yields in recent weeks has been driven by investors grappling with higher-than-expected government bond issuance. After the low-inflation, low-growth environment that prevailed during the 2008-2009 financial crisis and pandemic, a shift to higher long-term bond yields now would mark an abrupt reversal.
Brij Khurana said that if long-term bond yields continue to rise, it will lead to lower prices for other assets, and people who hold these assets will not spend as much as they did last year.