Fed Staff Economists Attribute "Far-Forward Interest Rate" Rise to Real Risk Premiums

Federal Reserve Board staff economists argued that a "remarkable" rise in far-forward nominal interest rates reflects a repricing of long-term economic risks rather than shifting inflation expectations.

In a FEDS Notes article, the authors examined why the "9-to-10-year forward Treasury rate" has seen its largest five-year increase since the early 1980s. They observed that this surge has occurred even as "the 10-year Treasury yield hovered ... above 4 percent despite" the Federal Open Market Committee ("FOMC") "cutt[ing] the target federal funds rate" by 175 basis points. The authors argued that the rise in rates is driven by "heightened perceived risks of future adverse economic supply shocks and increased concerns about future federal deficits," marking a return of "old risks" from previous decades.

The authors found that the rise is not attributable to higher expectations for future inflation or inflation risk premiums, both of which have remained stable near the 2 percent target. They viewed this stability as evidence of "investor confidence in the FOMC's commitment to keeping inflation" in check. Instead, they determined that the increase is driven almost entirely by a rising "far-forward real risk premium," which compensates investors for holding assets that lose value during poor economic conditions.

The authors identified two specific factors pushing the real risk premium higher. First, they highlighted the reemergence of "adverse supply shocks"—events that simultaneously push inflation higher and weaken economic activity—which had been largely absent between the 1980s and the COVID-19 pandemic. Second, they pointed to deteriorating fiscal outlooks, noting that Congressional Budget Office projections show the debt-to-GDP ratio on pace to surpass historical highs set during World War II.

The economists concluded that while the economy has entered a "new(ish) era of risks" involving supply shocks and fiscal sustainability, the Federal Reserve’s credibility has thus far prevented these risks from unanchoring long-term inflation expectations.