US Bond Yield Increases Driven by Fiscal Policy Risk, Says Former Fed Vice Chair Richard Clarida

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The government may face a shutdown due to spending disputes as early as next month. Clarida, who now serves as a global economic advisor at Pacific Investment Management Co., asserted that any upward movement in rates would stem from fiscal disarray in Washington rather than actions taken by the Federal Reserve. Despite the Fed’s significant influence, it isn’t the sole determinant of rates; fiscal policy also plays a critical role.

Investor concerns are growing regarding continuous fiscal deficits. This was underscored last month when Fitch Ratings downgraded America’s sovereign credit rating, forecasting a likely deterioration in the country’s finances over the next three years.

The US Congress is under pressure to agree on a temporary spending deal. House conservatives have pledged to disrupt negotiations unless their demands for reductions are met. A similar deadlock occurred earlier this year due to political disagreements over the debt ceiling.

Clarida pointed out that government debt relative to GDP has significantly increased in most countries. Two decades ago, this figure was below 50%, but it now exceeds 100%, including in the United States. Clarida served as the Fed’s vice chair from 2018 to 2022.

Regarding interest rates, Clarida anticipates that the Fed will maintain steady rates at its upcoming meeting while signaling its readiness for further policy tightening. He cautioned about a “disconnect” between the new approach of policymakers advocating for higher-for-longer rates and market expectations of rate cuts next year.

Finally, he highlighted potential risks associated with the Fed’s balance sheet reduction, a strategy known as quantitative tightening. The Fed has already divested about $1 trillion of its bond holdings. However, as this process continues, policymakers should remain alert to indications of escalating market stress.

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