Interest Rates, Inflation and the Uncertainty Tax

The last few months have seen a sharp rise in long-term interest rates.  Part of this can be ascribed to higher inflation expectations.  Part of it is likely due to a higher expected path for federal deficits.  However, perhaps the most significant driver of higher interest rates has been deep uncertainty about what the incoming administration will do on tariffs, immigration and the federal budget and the knock-on effect of this uncertainty on the Fed’s willingness to continue to ease monetary policy.

Some of this uncertainty may dissipate in the weeks following the inauguration.  However, both the economy and markets will remain vulnerable to either continued confusion or the actual enactment of policies with the potential to boost inflation and deficits. 

The Bond Market Selloff – Not Just About Inflation

Since hitting a low of 3.63% nearly four months ago, the 10-year Treasury yield has risen sharply to close, last Friday, at 4.77%.  While not pleasant for fixed-income investors or prospective home-buyers, this move, in itself, is not particularly ominous for the economy or financial markets.  Still it is important to understand what is going on, as the forces behind this rise in yields could impact both the economy and investment returns in the year ahead.

The first thing to note about the surge in yields is that most of the damage has been caused by a rise in real yields rather than inflation expectations.  To be specific, between September 16^th and January 10^th, the yield on a nominal 10-year Treasury bond rose by 1.14% while the real yield on a 10-year TIP rose by 0.80%, implying an increase in long-term inflation expectations of 0.34%.

I’ll get back to real yields shortly.  However, it is first important to recognize that the increase in inflation expectations is hard to explain except as a result of expectations and uncertainty surrounding the policies of the incoming administration.  This can be seen by taking a close look at the other drivers of higher inflation in recent years.

Inflation pressures can be broadly divided into four buckets:  Inflation from the labor market, from energy, from core goods and from sticky areas of services inflation such as auto insurance and shelter.  None of these have recently pointed to higher inflation.

On the labor market, last Friday’s December jobs report showed a strong 256,000 gain in payrolls and a welcome fall in the unemployment rate from 4.2% to 4.1%.  In addition, last Tuesday’s JOLTs report showed an increase in job openings to 8.1 million at the end of November, up from 7.8 million at the end of October and well above the 6.9 million counted as unemployed in early December.

However, despite this, wages for production and non-supervisory workers rose just 3.8% year-over-year in December, registering their smallest year-over-year increase since the pandemic.  Despite a strong economy, the percentage of workers quitting their jobs has fallen back to well below the average for this statistic in the five years before the pandemic.  Just 6% of private sector workers are in a union and the number of major strikes fell in 2024 from 2023.  The reality is that, no matter how many Americans still feel squeezed by post-pandemic inflation, either American workers are shy about asking for wage increases or American employers are effective at denying them – or both.  3.8% wage growth, in an economy experiencing 2% productivity growth, is entirely compatible with 2% inflation in goods and services.

On energy, oil prices backed up last week in reaction to new U.S. sanctions on the Russian oil industry.  However, a new U.S. administration could cut the military support that has allowed Ukraine defend itself for almost three years, potentially hastening an end to the war and, eventually, giving Russia a path back to more normal oil production and distribution.  Natural gas prices may remain higher for some time due to higher U.S. LNG exports.  However, pro-fossil-fuel policies from the incoming administration could boost U.S. supplies of both oil and gas, reducing any inflation threat from this area.

On supply chains, the December global manufacturing PMI vendor delivery index came in at a reading of 50.8, below its 25-year average of 52.4, indicating faster-than-average deliveries.  Moreover, the global composite PMI index at 52.6 shows moderate but certainly not booming growth outside of the United States.  In addition, a now 9% increase in the trade-weighted dollar index since late September, should further mute imported inflation, as will likely be apparent in this Thursday’s report on import prices.  Overall, outside of potential policy changes on tariffs, there seems little reason to fear imported inflation.

Finally, on sticky areas of inflation, the November 2024 CPI report showed a year-over-year increase of 2.7%, 78% of which came from a 4.7% year-over-year increase in shelter costs and a 12.7% rise in auto insurance.  This is, however, substantially better than a year ago, when 91% of a 3.1% overall CPI increase came from a 6.5% increase in shelter and a 19.2% rise in auto insurance.  We expect both of these sources of inflation to fall further in the year ahead, reflecting much weaker rental growth in new leases and declines in both new and used vehicle prices over the past year.

Putting all of it together, the data suggest that, in the absence of policy changes or shocks,  consumption deflator inflation, which amounted to 2.4% year-over-year in November, could drift down to 2.2% by the fourth quarter of 2025 and 2.1%, by the end of 2026 – not significantly different from what might have been projected back in September.

Clues from the SEP

This lack of significant change in inflation prospects also shows up Fed forecasts.  While the December SEP boosted expected headline consumption deflator inflation from 2.1% to 2.5% for 2025 and from 2.0% to 2.1% for 2026, it left inflation projections unchanged at 2.0% for 2027 and beyond.  This clearly stands in contrast to the TIPs market which effectively added 0.34% on average to inflation expectations for each of the next 10 years.

The December SEP also throws cold water on another possible reason for the increase in bond yields, namely, prospects for increased real economic growth.  While the median forecasts of the 19 FOMC participants acknowledged stronger growth in 2024, they boosted their expectations for 2025 growth by just 0.1%, to 2.1%, left 2026 unchanged at 2.0%, cut their 2027 forecast from 2.0% to 1.9% and left their long-term projection unchanged at 1.8%. 

One more likely contributor to the yield surge has been an increase in the amount of federal debt expected to be issued with single-party control of the White House and Congress compared to the divided government that looked possible before election day.

This Friday, the Congressional Budget Office will release updated 10-year projections for the budget deficit and debt.  We expect these numbers to show a deficit of roughly $2 trillion, or 6.5% of GDP for the current fiscal year, rising to $3 trillion or 7.0% of GDP by 2035, with the debt-to-GDP ratio climbing from 98.2% last fiscal year to roughly 125% of GDP by fiscal 2035. 

Moreover, as the CBO will stress, these forecasts will assume no extension of those 2017 tax cuts that are set to expire at the end of this year.  Markets, by contrast, are likely pricing in a full extension of these tax cuts, along some of the other tax cuts promised by the President-elect on the campaign trail.  Even with reductions in government spending, this likely implies higher deficits and part of the rise in real interest rates over the past few months may well be a rational consideration that a federal government that wishes to borrow more will have to pay higher rates.

The Uncertainty Tax

However, beyond any changes in expected inflation, economic growth or deficits, the rate surge may simply reflect uncertainty about the inflationary impact of potential tariff increases, immigration restrictions and fiscal stimulus.  The yields on all financial assets contain some risk premium and lenders need to be compensated not just for expected inflation but also for uncertainty surrounding that expectation.

Moreover, uncertainty about administration policies are already impacting the Fed’s decision-making.  Indeed, while the minutes of the December FOMC meeting, released last week, are peppered with references to policy uncertainty, one sentence stands out:

“Many participants observed that the current high degree of uncertainty made it appropriate for the Committee to take a gradual approach as it moved to a neutral policy stance”.

Consequently, the Fed reduced its projected rate cuts for 2025 from 100 basis points in the September SEP to 50 basis points in the December SEP.  This fact alone could account for a significant chunk of the recent increase in long-term interest rates.

Investment Implications

It could be, of course, that markets are taking a too negative view on the outlook for inflation, the deficit and Fed policy.  It may be that the President-elect, when in office, pursues less dramatic policies on tariffs and immigration.  It may be that the political reality of having to corral 218 votes in the House of Representatives waters down both the inflationary and deficit impact of the tax bill that will go through Congress later this year.  Or it could be that actions towards deregulation in the energy industry and elsewhere prove to be disinflationary, eventually allowing the Fed to ease more significantly.

However, for the economy and for markets, it would be best if the new administration and their Congressional allies clarified their plans as quickly as possible.  Uncertainty acts as a tax on the economy not just by adding to the risk premia on bonds but by causing businesses and consumers to delay decisions.  The most dangerous three words in economics are “wait and see”. 

Finally, for investors, the impact of the uncertainty tax on both the bond market and, more recently, the stock market are a reminder of the importance of finding and maintaining balance, following two years of extraordinary gains. 

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