The Fed Raised Rates. The Bigger Question Is Where They Settle.

On September 16 the Federal Reserve raised its policy rate by a quarter point, to a range of 3.75% to 4.00%. It was the Fed's first increase since July 2023, and the vote was unanimous.¹ Our mid-year outlook cited a hold through year-end as the base case, while noting that the risk was skewed toward tightening. The Fed has since raised rates.

In our view, the hike matters less than what it says about where rates are likely to settle. We think we are living in a world of higher interest rates generally, and that this is unlikely to change unless federal spending falls relative to the size of the economy — which we view as unlikely.

What the Fed Did

The Fed said inflation “remains elevated.”¹ Energy is part of that. Brent crude has traded above $100 a barrel this month,² and shipping through the Strait of Hormuz remains severely disrupted since the June framework agreement with Iran broke down.³ Overall PCE inflation, the measure the Fed's 2% goal is set against, was 3.7% in July. Core PCE, which excludes food and energy, was 3.3%.⁴ This is not only an oil story.

The median projection of Fed officials now implies one more quarter-point increase this year, no cuts in 2027, and a gradual decline after that.⁵

Why We Think Rates Stay Higher

The Fed sets short-term rates. Long-term rates — the ones that price mortgages, business loans and bonds — are set in the market. They reflect where investors expect short rates to go, plus a term premium: compensation for the risk that short rates do not turn out as expected.⁶ In our view, two things point to a higher long-term level.

The Fed's own estimate of the neutral rate has moved. Officials' median estimate of the long-run policy rate is 3.2%, up from 2.5% as recently as 2023.⁵

Federal spending is running well above its historical share of the economy. Outlays were 23.1% of GDP in fiscal 2025, against a 50-year average of 21.2%. Revenues, at 17.2%, were close to their own average of 17.3%.⁷ The Congressional Budget Office projects outlays rising to 24.4% of GDP by 2036, and calls the deficits it expects “especially large given the relatively low unemployment rates” it also projects.⁸

A growing share of that spending is interest. Net interest cost 3.2% of GDP in fiscal 2025, against a 50-year average of 2.1%, and CBO projects 4.6% by 2036. On our arithmetic, that 1.4-point rise is larger than the 1.3-point rise in total outlays — and CBO's projection already assumes, under current law, that discretionary spending falls to 4.8% of GDP, well below its 50-year average of 7.8%.⁸

The effect on rates is meaningful rather than dramatic. CBO estimates that each one-point rise in projected debt-to-GDP adds about 0.02 percentage points to long-run interest rates; recent IMF research puts it at 0.02 to 0.03, and Federal Reserve research at 0.03 to 0.04 for real 10-year yields.⁹ Applied to CBO's projected rise in debt held by the public from 99% to 120% of GDP by 2036, that is roughly 0.4 to 0.8 points — our arithmetic, not theirs. The IMF authors also find the link was close to zero for about two decades before 2010.⁹

None of this is a claim that rates are high by history. The 10-year Treasury yielded 5.11% on September 23, against an average of about 5.8% since 1962. It was the 2010s, at about 2.4%, that were unusual.¹⁰ As we wrote in August, today's level is historically unremarkable. Our view is that the low-rate decade was the exception and that the federal budget makes a return to it unlikely — not that a debt crisis is coming.

What Would Prove Us Wrong

Rates have fallen before despite heavy borrowing. A recession pulls yields down quickly: the 10-year averaged 1.8% in 2012 and closed as low as 0.52% in August 2020. Between 2008 and 2020, federal debt held by the public rose from about 39% of GDP to about 98% while the 10-year yield fell. Japan's government debt has exceeded 200% of GDP since 2010, yet its 10-year yield stayed near zero for much of that decade, although from 2016 its central bank was capping it.¹¹ Faster productivity growth, including from AI, would enlarge the economy the debt is measured against, though CBO estimates it would also raise interest rates; slower labor-force growth, CBO says, would lower them.¹² And one widely cited New York Fed model still puts the neutral real rate near 1%.¹³ Any of these could leave rates, or the debt burden, lower than we expect.

Questions Worth Asking About Your Own Plan

These are questions, not recommendations. What any of them means depends on a particular family's holdings, obligations and plan.

What does your borrowing cost if short-term rates stay near 4%? Securities-based lines of credit, business lines and construction loans usually float. Was the plan built on their returning to 2% or 3%?

Does your plan count on bonds to offset stock losses? When inflation drives rates, stocks and bonds can fall at the same time, as they did in 2022.¹⁴ Higher yields mean more income, but the 10-year yield has risen from a December average of 4.14% to 5.11%, which lowers the price of bonds already held.¹⁰

Which real estate or private holdings were valued or financed at lower rates? Loans are refinanced at the rates in place when they come due, and valuations can reflect today's rates rather than those in place when the asset was bought.

What is your cash earning, and what if that changes? Three-month Treasury bills yield about 4.2%, against an average of about 0.6% from 2010 through 2019.¹⁰ Whether that lasts depends on the same forces.

We are not making a call on the Fed's next meeting. Our view is that the rate environment of the 2010s is unlikely to return soon, and that it is worth knowing which of your assumptions depend on it. If you'd like to talk through how this applies to you, we're glad to.