ÀÖÓ㣨Leyu£©ÌåÓý¹ÙÍø

Ìý

1. Global interest rates have shifted up. Interest rates across the globe have increased and are unlikely to return to the lows we saw in the 2010s or the immediate aftermath of the pandemic.
2. Curbs to global growth. Higher borrowing costs curb big spending decisions by firms and households, while limiting the extent to which governments can offset economic downturns.Ìý
3. Escalating default risks. Escalating interest expense ups the risk of a sovereign debt default, notably but not uniquely, in emerging markets. A broader financial crisis cannot be ruled out, given widening junk bond spreads and the proliferation of private, less transparent credit markets in recent years.ÌýThe implementation of tariffs will increase inflation in the near term and possibly beyond. This exacerbates the risk of higher for longer interest rates, which, in turn, ups the risk of a sovereign or private default. In the short run, lower rates are unlikely, absent a severe global contraction.ÌýÌý

The underlying level of real, or inflation-adjusted, short-term interest rates consistent with the economy operating at full employment—the so-called neutral rate—has edged higher. This can be seen most dramatically in what are known as the Summary of Economic Projections (SEP) by the Federal Reserve. The long-term expected fed funds rate, which is a proxy for the Fed’s estimate of neutral, jumped by one-half percentage point between late 2019 and its most recent projections in March 2025.Ìý

A host of factors contributed to that increase. The largest single factor was the remarkable resilience that the US economy showed in the wake of the pandemic. A surge in investment and productivity growth helped. The Fed was not alone among central banks in moving estimates of the non-inflationary or neutral rate higher.Ìý

Inflation expectations are up

Recently, inflation expectations in the US have risen as illustrated by consumer and financial market measures in Chart 2: Consumers' expectations have soared, both one year and five years out, with most citing concerns about the implications of tariffs. The Treasury Inflation-Protected Securities (TIPS) spread, which is the nominal 5-year Treasury yield minus the corresponding TIPS rate, shows a 50-basis point increase in inflation expectations since September 2024 and an increase of roughly 25-30 basis points compared to the average for all of 2024.Ìý

The Blue Chip Survey of professional forecasters is equally worrisome. It now anticipates inflation in 2025 to be about one-third of a percentage point higher than it projected in November 2024.Ìý

We have seen similar concerns abroad, with the central banks of some of our closest allies and trading partners warning about the risks of stagflation given the push to retaliate against US-initiated tariffs.Ìý

Business fixed investment, consumer demand for big-ticket purchases (vehicles, appliances, etc.) and demand for housing are all among the most interest-rate sensitive sectors. Add a surge in economic policy uncertainty and some sectors of the global economy are seeing a paralysis set in.ÌýÌý

Capital spending is typically financed with debt, so the net return on a given investment falls as interest rates rise. This can result in some projects being shelved or scaled back. The more rates rise, the more projects that get scaled back or skipped altogether, weakening overall business fixed investment.

Housing demand is very interest sensitive. Most home purchases are financed with a mortgage. Given the size of a typical mortgage, even relatively small changes in mortgage rates can add hundreds of dollars to a monthly mortgage payment. This can lead to homebuyers being priced out of the market, lowering their bid or scaling back their aspirations. The reduced demand for housing will result in less new construction and weaken home prices.

Consumer durables purchases are often financed on credit, especially light vehicles. If higher auto loan rates are here to stay, consumers may hold on to their existing vehicles longer, choose less expensive models, or switch to used vehicles. That weaker demand for new vehicles restrains auto production and hinders GDP growth. ÌýÌ�

Higher interest rates raise government debt servicing costs, which leave governments less room to counter recessions. They may up the need for austerity measures down the road, which could deepen the depth of a downturn when it does occur.

The higher interest rate path we now expect for 2025 and heading into 2026 is a major factor that led us to mark down our projection for GDP growth in the US in 2025 and beyond compared to just few months ago. �

Escalating default risks

Higher rates put pressure on government debt servicing, raise the risk of default and therefore associated risk premia, and accentuate the risk of contagion.Ìý Rising risk premia and the corresponding decline in the value of sovereign debt adversely impact the balance sheets of investors and banks increasingly loaded with that debt. Global sovereign debt continues to climb absolutely and as a share of global GDP (Chart 4). Debt stress in economies with large amounts of outstanding debt can result in rising volatility, higher risk premiums, increased financing costs and eventually spill into emerging markets (EMs). Global inequality worsens as EMs are forced to take on exorbitant interest rates or are locked out of the market all together.Ìý

The default risks are not limited to sovereign debt. The spreads between investment grade bonds and lower rated bonds have widened in response to concerns about the pressure tariffs could exert on earnings. This is occurring at the same time that non-bank lending has soared and become increasingly opaque. The rating agencies are beginning to raise red flags about the size of that debt, the underwriting standards and whether it can weather the firestorm of tariffs. No one knows how significant the contagion risks are, only that they exist and, if realized, could ripple through the global economy much like the subprime debt crisis of 2008-09.Ìý

The historically low long-term rates experienced in the 2010s and the pandemic’s immediate aftermath are a thing of the past. Elevated rates are working to slow economic growth, constrain fiscal policy and add to financial fragility.Ìý

The implementation of tariffs will increase inflation in the near term and possibly beyond. This exacerbates the risk of higher for longer interest rates, which, in turn, ups the risk of a sovereign or private default. In the short run, lower rates are unlikely, absent a severe global contraction. Ìý