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In this week’s Grumpy Economist Weekly Rant, John Cochrane considers what may be driving the global surge in long-term interest rates. Higher rates could reflect persistent inflation, expectations of future Federal Reserve tightening, or simply a return to historically normal real interest rates after two unusual decades.
A more consequential possibility is that bond markets are becoming less willing to finance heavily indebted governments on favorable terms. Cochrane points to weak demand for long-term Treasury debt and the government’s shift toward shorter-term borrowing as potential warning signs. Markets do not reveal which explanation is correct, but these competing possibilities provide a framework for understanding what rising rates may be telling us.
Read: “Interest Rate Surge?”, The Grumpy Economist
Transcript
Hi. I’m John Cochrane, senior fellow here at the Hoover Institution, and welcome to my Grumpy Economist’s Weekly Rant. Today, I’m gonna rant about interest rates. Long-term interest rates are surging, and there’s lots of commentary about why.
Now, normally, I don’t do market commentary. It doesn’t last very long because markets always change. And the great economist Friedrich Hayek told us nobody ever knows why prices go up or down. Markets aggregate the information of millions of different people, and they tell you a price that tells you what to do, but they don’t tell you why that price moved. If we could even know why the price of strawberries goes up or down, communism would’ve worked, and it didn’t.
Still, there are some possibilities, so let’s explore the possible stories for why interest rates are going up. The first one: maybe people expect a lot of inflation in the future.
Inflation is still elevated. Maybe it will get out of control. That makes sense. People demand a higher interest rate upfront if they know they’re gonna be paid back in money that’s worth less later.
Here, though, if you compare the Treasury inflation-protected yield with the regular yield, you notice that the spread has not widened that much. So that argues against it being expected inflation, though the Treasury inflation-protected yield is sometimes a poor signal.
Maybe people expect the Fed to tighten in order to fight inflation and that the Fed will be successful, which is why inflation expectations aren’t going up. That story, too, makes some sense. Long-term interest rates average what people think short-term interest rates will be in the future. So, if they expect the Fed to tighten in the future, you’ll see long-term interest rates go up.
Maybe we’re just seeing real interest rates return to normal. The normal situation in our economy for years and years was, say, 2% inflation, two to 3% real interest rates, and so four to 5% nominal interest rates, which is back where we are. It was the last 20 years that were unusual, and there’s lots of stories about why things have changed. The supposed savings glut and the lack of good investment opportunities have all turned around.
Maybe we’re just going back to normal. Or maybe the bond market vigilantes are finally coming.
Notice, this is a phenomenon throughout the world. UK, Germany, Japan- other interest rates are going up just like ours are, but not Switzerland. What’s different about Switzerland? Much better monetary and fiscal policies. All the rest of us have big debt problems. So, if it’s the debt vigilantes coming, it’s a global sovereign debt rout that’s on its way, except for Switzerland.
Maybe that’s true. Maybe it isn’t. We’ve worried about it for a long time, and it hasn’t yet. You see some signs of this, however, in the long-term markets. There’s a feeling that demand for 10-year Treasuries is weak, and you can see it in the actions of our government.
Our Treasury Secretary, uh, Bessent, just helped Japan to strengthen the yen without selling its long-term Treasuries by having the Fed give it the money to do it. He’s worried about selling long-term Treasuries.
And more recently, Bessent announced that he would buy long-term bonds and issue short-term bonds instead to try to prop up the prices of those long-term bonds. That makes sense if the underlying problem is liquidity or dysfunction in the long-term bond markets. Then it’ll have an effect, but only a short-term effect.
Shortening the maturity is also something that happens on the way to big bond market problems. Governments, like businesses, that are close to bankruptcy find they’re unable to borrow long-term and have to borrow shorter and shorter and shorter until the day that everything blows up.
Let’s hope that’s not true.
So, what’s the answer? I don’t know. I still don’t know. But at least I gave you a bunch of stories that I hope will help us to think through which is the right answer and what will happen in the future.
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John H. Cochrane is the Rose-Marie and Jack Anderson Senior Fellow of the Hoover Institution at Stanford University. An economist specializing in financial economics and macroeconomics, he is the author of The Fiscal Theory of the Price Level. He also authors a popular Substack called The Grumpy Economist.