Global bond yields are touching multi-year highs, and as the Federal Reserve meets to set interest rate policy this week officials will have to discuss whether this is re-pricing back into ranges last seen before the 2007-2008 global financial crisis or a structural turn in the global economy that will require higher interest rates for years to come.

On the one hand, the high rates may be the result of temporary supply chain frictions and energy insecurity. But real interest rates, or the return on money apart from inflation compensation, have also moved up and may remain higher as demands for capital increase with the artificial intelligence boom and possibly higher productivity, indicating a more structural change.

Going into the meeting, there was an emerging tension among policy makers. There are those who have resisted raising rates on an expectation that the Iran War energy shock and the tariffs will eventually subside, leaving inflation back on a path toward the 2 percent target. There are others who say a world of rolling supply shocks amid geopolitical tensions is creating inflation persistence that won’t go away without higher policy rates.

While the Fed has held rates steady this year, the European Central Bank, the Reserve Bank of Australia and Bank of Japan have all pushed their policy rates higher.

But there are signs the Fed may be changing that approach. New Chairman Kevin Warsh has become more pointed about inflation. He warned in his Jackson Hole central bank symposium remarks that “we have work to do’’ if inflation doesn’t start moving toward the 2 percent target.

The consumer price index rose 3.4 percent for the year ending August and traders now price in about a 94 percent probability of a quarter-point hike at the September 15-16 Fed policy meeting, as well as one more by the end of the year.

A historical blip of low rates

For more than a dozen years, starting with the global financial crisis and rolling into the pandemic through mid-2023, U.S. government 10-year yields were below 4%. Total assets held by the Fed expanded to $7.7 trillion by the end of 2023 from $871 billion at the end of 2006, partly due to trillions of dollars in Fed Treasury bond purchases through market stabilization and quantitative easing programs.

Taking medium- and longer-term Treasuries out of the market helped pull longer-term interest rates down by lowering the extra compensation required by investors to hold such securities. The Fed also cut and held its policy rate at zero for seven years following the financial crisis and for two years during the pandemic.

Inflation measured by the Fed’s preferred target, the personal consumption expenditures price index or “PCE,’’ averaged just 1.4 percent from 2009 to 2019 as the U.S. economy slogged along with sluggish job growth.

That phase is starting to look like a historical anomaly.

Government 10-year yields are now back in ranges seen before the global financial crisis, partly because both inflation and real interest rates are higher. PCE inflation rose 3.7 percent for the year ending July. The yield on the U.S. 10-year note apart from inflation compensation is around 2.6%, the highest since the global financial crisis.

The back to normal case for rates

One way to consider today’s higher rates is a “return to normal” after the crisis pothole.

There’s evidence for this view. Demand for capital is high because of the artificial intelligence buildout which could boost U.S. productivity in years ahead. That requires higher interest rates to pull savings in. Private sector capital needs are competing with the government’s own need for funds at longer maturities. Years of undisciplined fiscal policy have doubled the debt-to-GDP ratio over the past two decades to over 100 percent in the U.S.

The case for a re-normalization of rates after the pothole is a bet that rates don’t go much higher from here as shocks subside and government policies are eventually oriented toward a convincing plan to bring the deficit and inflation down.

Looking at prices in markets, the 10-year Treasury currently yields around 5 percent. Real yields on ten-year TIPS securities are about 2.6 percent. The difference between these two yields is a market-based measure of inflation compensation of 2.4 percent plus an inflation risk premium. Adjusted for the usual gap between CPI inflation and PCE inflation, that suggests investors anticipate average expected inflation to be close to the Fed’s 2 percent target over the next 10 years.

Regime change may already be taking place

Forward markets, however, hint that a regime change is taking place, one where rates will need to be higher to achieve the Fed’s inflation target. Real one-year yields, a proxy for the real policy rate, nine years from now are at 3.3 percent, higher than just before the global financial crisis.

Of course, uncertainty is large around any prediction. There is no near-term resolution for either the Iran or Ukraine wars, and in the U.S. new rounds of tariffs and trade wars continue to flare up. There is no real fiscal stability plan.

Forecasts from the Fed would benefit from scenarios that encompass the possibility that interest rates are signaling something more structural and lasting than a series of temporary shocks.

It is hard to predict a return to the old normal amid continued geopolitical instability, trade and hot wars, and a more interventionist government in the economy to build national economic resiliency. Anti-globalization nationalists are also ascendent in other developed economies.

While no central banker wants to commit to a rate path amid huge macro and geopolitical uncertainties, any discussion of what it will take to get inflation back to target must include the possibility of a regime change scenario.

That foresees a world of disrupted trade through tariffs and conflicts over chokepoints, more costly on-shoring and less immigration, while political systems test the limits of spending to fund their militaries.

The outlines of this scenario are already visible, and the risk is inflation is higher and more persistent than expected. With inflation above target for more than five years in the U.S., it is looking increasingly necessary to run more restrictive policy to return inflation to the Fed’s 2 percent goal, even if the AI boom may deliver at some point in the future the productivity boost we all hope for.

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A version of this newsletter first appeared on Marketwatch as an opinion piece. To receive more newsletters from Fabio directly to your inbox, subscribe on substack.