Soaring interest rates enemy No. 1

Inflation’s days may be numbered, beaten back by round after round of interest rate hikes delivered by the Federal Reserve.

But the Fed’s cure is causing its own pain.

The steepest bond rates in two decades are inflicting losses on investors and rekindling concern that the economy will skid into a recession. They are also threatening to disrupt the US government bond market — the beating heart of the global financial system — and the federal government’s ability to fund itself.

Put simply, it may take longer for rates to fall than it did for the Fed to increase them. And rates may settle at levels significantly above where they were before the pandemic.

The implications for the economy are broad.

The latest: The yield on the US Treasury’s 10-year note ended last week at a 16-year high of 4.8 percent. (Yields rise when prices fall.)

The 10-year Treasury is pivotal because it’s considered the “risk free” return against which most investments are weighed. It also influences mortgage rates, and last week the average rate on a 30-year fixed loan reached 7.49 percent, a neighborhood home buyers haven’t visited since the end of 2000.

Rewind: Bond prices fell at the start of last year, driving yields higher, as it became clear that rampant inflation would force the Federal Reserve to tighten credit after years of virtually free money.

The central bank hiked its federal funds rate 11 times in the past 18 months, from near zero to a range of 5.25 percent to 5.5 percent. Inflation responded: The consumer price index rose at an annual 3.7 percent pace in August, down from the post-COVID peak of 9.1 percent in June 2022.

The Fed will likely boost rates one more time this year, especially after Friday’s news that the job market picked up strength last month.

But even after the central bank hits pause, the rapid run-up of Treasury

yields is a strong signal from investors that they expect borrowing costs to stay elevated for some time.

What’s at stake: When credit is tight, consumers typically spend less. Businesses delay expansion plans.

Higher rates also squeeze banks by reducing the value of their bond holdings. To preserve capital, banks often scale back lending, which acts as another brake on the economy. (In extreme cases — like Silicon Valley Bank and First Republic Bank earlier this year — bond losses can spark a fatal run on deposits.)

When consumers, businesses, and lenders all pull back, the odds of a recession increase.

Worry about the government: When the Fed slashed interest rates during the Great Recession, the federal government could cheaply fund deficits and refinance outstanding debt. Moreover, to keep rates low, the central bank bought trillions of dollars in Treasuries and mortgage securities.

It’s a different world now. The Fed is selling its bonds and mortgage debt, which has the effect of tightening credit and pushing up rates just as the gap between federal spending and revenue is widening.

The Congressional Budget Office estimated in February that the federal budget deficit would be $1.4 trillion in the fiscal year ended Sept. 30, up from $1.3 billion a year earlier. Debt held by the public will rise to $46.4 trillion in 2033 from $25.7 trillion in the year just ended, the CBO projected.

Bigger deficits mean the Treasury will have to sell more debt. To find buyers, it will have to offer higher yields. And that will cost taxpayers more.

The counterargument: A recession isn’t inevitable.

While slowing, the economy remains in good health. The jobs report on Friday showed that employers hired last month at the fastest pace since January without a corresponding rise in wages.

When the Fed signals that it’s done raising interest rates, investors may gain the confidence to resume snapping up Treasuries, mortgage securities, and corporate bonds.

The surge in bond yields might make it easier for the central bank to stop hiking because financial markets will have done the job of tightening credit and further cooling inflation themselves.

The bottom line: Prices have fallen over the past year for many items that sparked inflation during the pandemic: grocery staples like milk and eggs, gasoline, used cars and trucks, furniture, appliances, airfares. Housing costs are high but improving.

The economy is at a crossroads. Whether growth continues or a recession ensues hinges on the direction of interest rates.

All eyes remain on the Fed.