A problem that’s currently causing headaches for central banks around the world is the sharp rise in long-term interest rates seen recently. This problem, accompanied by falling share prices, could potentially be a wet blanket for economies that are finally starting to get back on their feet after the Covid-19 crisis. The major epicenter of these rising interest rates is the US. Although the rate for ten-year Treasury Bonds was below 1.0% at the start of the year, it temporarily rose to around 1.6% at the beginning of March. That being the case, the response by the Federal Reserve Board (FRB) has been drawing particular attention.

From “positive” to “negative” interest rates increases

Underlying this rise in long-term US interest rates is the observation that with the US economy recovering from the Covid-19 crisis and continuing to improve, the inflation rate will follow suit and climb going forward. The massive $1.9 trillion economic stimulus package proposed by the Biden Administration (equivalent to 200 trillion yen) has only reinforced this observation.
The “break-even” inflation rate—which is calculated based on inflation-indexed bonds (five-year) and is taken to reflect the inflation rate outlook in the financial markets—rose as high as 2.5% in March, eclipsing the FRB’s 2% price target. This is in fact the highest level reached since 2008.
A rise in long-term interest rates also reflects improvement in economic and price developments, and if such a rise does not undermine the stability of the economy or the financial markets overall, it can be considered a “positive” interest rate increase. To be sure, at first this interest rate increase was proceeding in lockstep with a rise in stock prices, and was therefore a “positive” increase.
However, since the latter part of February, the rise in long-term interest rates has taken on a more conspicuous aspect in causing stock prices to fall. There is a sense now that this rise has turned into a so-called “negative” interest rate increase, one that could destabilize the financial markets as a whole, and possibly even douse the flames of economic recovery.
In actuality, one might think that the inflation outlook in the financial markets went too far. However, even if that were true, if a substantial rise in long-term interest rates or drop in stock prices were really to occur, that would lead to economic deterioration, which central banks would find unacceptable. In addition, a rise in interest rates for Treasury bonds—considered a safe asset—would trigger price adjustments in securitized products, corporate bonds, and various other types of risky assets. Such a development could bring about serious losses for financial institutions, and it could even lead to a financial crisis.

A “taper-less tantrum”

The recent rise in long-term interest rates recalls to mind the “taper tantrum” that happened back in 2013. The “taper tantrum” was an event that occurred in May 2013, when then-FRB Chair Bernanke’s suggestion that policymakers would be winding down their quantitative easing program and curtailing the Fed’s asset purchases sent shockwaves through the financial markets. The “taper” refers to this contraction of the asset purchase volume, while the “tantrum” suggests the ensuring market turmoil. Developing nations in particular experienced currency depreciation and chaos in their bond and stock markets, stemming from concerns over capital flight from these nations back to safer US assets.
This happened at a time when the US economy was just again finding its footing after the blows suffered from the financial crisis. In a sense, that situation overlaps with the background leading up to the current increase in long-term interest rates. The major difference this time, however, is that the rise in long-term interest rates and volatility of the financial markets have occurred even though the FRB has not hinted at drawing down its asset purchase program. This amounts to a “taper-less” tantrum, as it were.

Revisions to the FRB’s inflation target policy framework also a factor?

Perhaps the growing fears of inflation in the US and the rise in long-term interest rates have to do with the revisions to the inflation target policy framework announced by the FRB last year. The FRB stated that, “following periods when inflation has been running persistently below 2 percent” it would permit inflation to exceed the target level for a certain period of time, with the aim of “achieving inflation that average 2 percent over time”. This new and rather dovish policy tack, which allows inflation to surpass the target level as a sort of “overshoot”, was conceivably one reason behind the recent increase in the market’s inflation forecast and the rise in long-term interest rates.
It would appear that this new policy line has caused fears to surface in the markets that inflation may accelerate beyond control in the future. If that actually were to happen, it would lead long-term interest rates to rise, based on the observation that sooner or later a major increase in policy interest rates would be implemented.
If the FRB were to give any sign that it might retract this new policy and quickly raise short-term policy interest rates, the market’s inflation observations could perhaps be quelled, and the increase in long-term interest rates might also pause.
However, repealing this new policy framework—which was only just introduced last year with great fanfare—would surely be inconsistent and could possibly damage confidence in the Fed’s fiscal policies, and thus it would likely be difficult to achieve. In addition, even if such a policy revision were to be made, there is no guarantee that it would curb the rise in long-term interest rates.

Countries are stuck with their monetary policies

Circumstances are much the same for other central banks throughout the world. Even if they were to send a message to their markets that they won’t be raising policy interest rates right away, inflationary expectations would still mount, and it could instead lead long-term interest rates to rise. On the other hand, even if they suggest the possibility of raising policy interest rates swiftly, long-term interest rates could still end up rising.
Within the European Central Bank (ECB), it seems that discussions are now underway to increase the purchase volume of government bonds in order to restrain any rise in long-term interest rates. However, since this is really nothing but a furtherance of quantitative easing, it could very well fuel expectations of economic overheating or inflationary fears, thus bolstering the increase in long-term interest rates.
After the unprecedented Covid-19 crisis, economic conditions around the world are now reaching a delicate juncture. With this going on, central banks are being compelled to implement difficult monetary policies. For some time, it’s likely that these banks will continue to be trapped in this situation with no way out.
In the absence of any major events, such as the Biden Administration significantly revising its fiscal expansionary policy in light of rising long-term interest rates, or a sudden drop in stock prices calming market fears of overheating, stifling the rise in long-term interest rates with central bank policy measures alone will be difficult for the time being.
For the past year, central banks all over the world have made exhaustive efforts to handle a deteriorating economic environment caused by the Covid-19 pandemic. Now that their policies seem to be bearing fruit at last, the central banks of the world find themselves faced with a new challenge.