The Federal Reserve resumed monetary tightening in September, and the conversation has already shifted to the central bank’s inability to impact the key sources of inflation. The path back to 2% inflation looks harder to believe than it has for some time.
The uneasy truth is that monetary policy has little impact on cost-push inflation, and the Fed faces it just as growth appears to be accelerating on the back of capital spending and manufacturing. Financial conditions are a long way from tight, and credit remains plentiful.
The recent rise in bond yields will be felt in rate-sensitive areas such as housing and consumer spending, but it is unlikely in the near term to produce the kind of slowdown that eases inflationary pressure. Lower inflation will come either from cheaper commodities or from a slowdown the Fed engineers. The latter would require significant further action and a reversal of animal spirits.
Fiscal policy is loose, which adds demand to an economy that already has plenty. It is an inflationary driver, and one that the central bank is unable to control. Then there is capital spending. The AI build-out has pushed manufacturing and investment sharply higher over the past year. Much of that money is already committed, so a higher policy rate barely registers with the companies spending it. Growth and earnings are strong, which helps limit defaults and the cost of financing.
The labour market has stopped helping too. For much of the year, softer hiring looked as though it might cool the economy on its own. That softness has started to reverse.
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Commodities are the hardest part. Oil is higher because supply is short, and the tightness in diesel and jet fuel shows how far the shortage has spread. Raising rates does nothing for supply. It squeezes demand in other sectors, so the people who pay for a shortage are borrowers who had nothing to do with it. That is an unfair outcome, and there is no way round it.
Bond investors have noticed. 10-year yields are above 5%, and a large part of that reflects a higher term premium, the extra yield people want before they will lend to the government over longer periods. The premium has been rising as confidence in the path to target has fallen. It is this number the Fed should worry about most.
So, the Fed will probably keep raising rates, even though rate rises are a poor answer to the current inflation problem. If its path stops looking credible, the tightening happens anyway through longer dated yields, and this hits the economy far less precisely than policymakers would like. The Fed cannot fix the diesel market. What it can do is try to keep its commitment intact through the limited tools at its disposal.
Criticism comes easily at times like this. ‘The Fed is behind the curve’ becomes a simple answer to a complex inflationary backdrop. The committee is dealing with a supply shock it cannot cure, a fiscal stance it does not set, while an investment boom carries on regardless of what happens to rates. Constrained is a better word for its position than failing. And when the argument turns to competence, the harder question gets lost: who pays to restore credibility?
It will be the households and businesses least able to afford it. How far rates must rise depends on where the neutral rate sits, and nobody, the Fed included, is likely to know until something gives.
The strain already shows in the yield curve. Short-dated yields move with policy. Longer-dated yields are being pushed around by the term premium and by the sheer amount of debt looking for buyers. The curve has flattened quickly, and borrowers are paying more at both ends. Credit spreads have started to widen, though they are still close to historic tights, which is normal given the strength of corporate profits.
Markets have taken a lot in their stride this year, including geopolitical turmoil that might once have rattled them. A sustained tightening campaign is a different kind of problem, and equity leadership has started to shift. Value and smaller company shares led for most of 2026 and have lagged over the past few weeks as investors scale back their hopes for 2027.
Fortunately, we have not had to react to higher yields as we were already positioned for this backdrop. We hold shorter-dated government and corporate debt and favour larger companies in most client portfolios, with some exposure to smaller companies and value in the UK and Asia where risk budgets allow.
A flattening yield curve works against these positions, and we need to look again at our riskier credit holdings, even with a backdrop of limited defaults. As we monitor rising monetary pressures, we are ready to adjust client portfolios to improve risk-adjusted outcomes for them.
Fahad Hassan is CIO at Albemarle Street Partners
