Surge in Long-Term Interest Rates Defies Conventional Economic Theory

The recent surge in long-term interest rates has puzzled economists and financial experts. According to conventional economic theory, longer-term interest rates are determined by 'real' forces such as supply and demand for safe assets, demographics, and technological progress. However, this framework fails to explain the sharp rise in long-term rates since August 2020.

A recent paper by Christensen and Rudebusch examined whether worsening fiscal prospects or AI breakthroughs could explain the rise in the natural rate of interest (r*). They analyzed key dates associated with fiscal-policy developments and major generative-AI news, but found no substantial evidence that these events contributed to the observed rise in long-term rates.

However, their analysis revealed a surprising pattern: changes in long-term rates during FOMC windows did not account for any of the observed increase in long-term interest rates. This challenges the conventional view that monetary policy has no influence over long-term real rates.

The researchers also found that news unrelated to r* played a significant role in driving trends in long-term rates. Specifically, nonfarm payroll (NFP) releases and speeches from prominent monetary policymakers at the Federal Reserve Board accounted for 90.5% of the observed rise in the 10-year nominal Treasury yield.

The study suggests that long-term real rates may be best viewed as quasi-indeterminate from a purely functional perspective. This implies that the central bank's estimate of r* is not a strong anchor for monetary policy, and that perception errors with respect to r* can have slow-to-correct consequences.