The recent surge in far-forward nominal concerns over federal deficits. Even so, we find no evidence that rising far-ahead inflation risk has contributed to this trend. While this might seem counterintuitive given that supply shocks and fiscal challenges have historically—and in other nations—been linked to higher inflation, it is plausible because monetary policy can temper the inflationary consequences of such shocks. Overall, our findings point to a new(ish) era of risks for asset pricing, where two classic concerns—adverse supply shocks and fiscal instability—have resurfaced, even as the Federal Reserve’s credibility in managing inflation remains intact.
Figure 1. Levels and Five-Year Changes in Far-Forward (9-10 Year) Nominal Treasury Rates
Notes: The left panel depicts the nominal 9-10 year forward rate from smoothed yield curves. The right panel depicts 20-quarter rolling changes in the 9-10 year forward rate.
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We reach this conclusion through a two-part process. First, we argue that three components of far-forward rates derived from a standard asset-pricing decomposition—far-forward expected inflation, far-forward inflation risk, and expected far-forward real short-term interest rates—have not risen significantly in recent years. This implies that the remaining component, the far-forward real risk premium, must have increased. The second step involves applying structural asset pricing logic to identify theoretically sound explanations for the apparent growth in far-forward real-risk premiums, subsequently narrowing those possibilities based on empirical economic risk estimates from Engstrom (2025) and official federal deficit projections.
Throughout this discussion, we rely on a standard decomposition of far-forward nominal Treasury rates:
$$ text{far fwd rate} = E[pi] + text{prem}[pi] + E[{r^f}] + text{prem}[{r^f}] $$
In this expression, the far-forward rate is the sum of four components: The far-forward expected rate of inflation, $E[pi]$, a far-forward inflation risk premium, $text{prem}[pi]$, the far-forward expected real rate, $E[{r^f}]$ and a far-forward real risk premium, $text{prem}[{r^f}]$.
Far-forward expected inflation and its corresponding risk premium do not appear to have risen over the past few years. This is primarily because the compensation investors demand for future inflation and inflation risk—measured by the spread between nominal forward Treasury yields and forward yields on Treasury Inflation Protected Securities—has not increased (Figure 2, left chart, thick red line). Furthermore, empirical survey-based measures of expected long-run inflation have remained steady. For example, the thin black line in the left panel of Figure 2 illustrates the perceived long-term inflation target (labeled pi-star) utilized in FRB/US, a model available on the Federal Reserve’s website. This metric has also remained largely consistent in recent years. Many would credit the apparent stability of far-forward inflation compensation and expectations to investor trust in the FOMC’s dedication to maintaining inflation near its 2 percent goal. Moreover, inflation compensation and survey-based far-forward inflation expectations have tracked very closely, both hovering near 2 percent recently, suggesting that the far-forward inflation risk premium—the difference between the red and black lines—has been near zero and has not grown.
Figure 2. Far-Forward Expected Inflation and Real Interest Rates
Notes: The left panel depicts in thin black variable “PTR”, labeled “pi-star” from the public variable file from FRB/US at the Federal Reserve Board website. (Data for 2025:Q2-Q3 is imputed from the Survey of Professional Forecasters). Plotted in thick red is 9-10 year forward inflation compensation derived from smoothed nominal and inflation-protected Treasury securities. The right panel depicts estimates of r-star from Holston, Laubach and Williams (2017), thick red line, and survey-based estimate from the BlueChip survey, dotted blue, and a purely statistical model of the trend in short term real rates, thin black.
ral Reserve Board of Governors, FRB-NY
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Far-forward expected real short-term interest rates may have risen recently, but likely not enough to account for much of the increase in far-forward rates. One estimate of the real short rate is the “neutral” level of real interest rates—the level that neither stimulates nor restricts economic growth—from Holston, Laubach and Williams (“HLR”, 2017), which is accessible on the Federal Reserve Bank of New York’s website. As the thick red line in the right panel of Figure 2 demonstrates, this measure has trended downward for decades and currently sits at the low end of its historical range. Two other estimates are also shown: one for far-forward expected real rates from the BlueChip survey and another from a purely statistical model of the far-forward expectation for real short rates, represented by the blue dotted and thin black lines, respectively. These two estimates share notable low-frequency dynamics with the HLR estimate, specifically a secular decline from 2000 to 2020. However, unlike the HLR, they show some upward drift in the post-pandemic era, likely because survey participants are now looking beyond the period of exceptionally low real short rates seen during the pandemic, and the statistical trend model tends to look past shorter-term fluctuations like the sharp real rate declines during that period. Based on these three estimates—all of which are imperfect—we infer that while expected long-run real short rates may have risen slightly over the past five years, that shift is likely minor compared to the increase in far-forward rates shown in Figure 1.
Given the apparent stability of far-forward expected inflation and the far-forward inflation risk premium, combined with only a modest rise in expected far-forward real short-term interest rates, we are left with rising far-forward real risk premiums as the primary explanation for the marked increase in far-forward rates in recent years.
For a historical perspective on the evolution of estimated far-forward risk premiums, Figure 3 displays estimates using a methodology inspired by Bauer and Rudebusch (2017). To determine the total far-forward risk premium, we subtract measures of far-forward expected inflation and far-forward expected real interest rates from the 9-10 year forward Treasury rate, with the sum of those two elements shown by the thin black line; to isolate the far-forward real premium, we also subtract the far-forward inflation risk premium. The estimate of the total far-forward risk premium, shown by the thick red line in Figure 3, is currently at approximately its 85th percentile since 1971, though it remains 200 basis points below the peaks seen in the early 1980s. It has climbed about 200 basis points over the last few years, and this recent growth is attributed entirely to the rise in real far-forward risk premiums, indicated by the dotted blue line. The fact that the total risk premium was significantly higher in the 1980s compared to today might reflect a higher inflation risk premium during that period when the Federal Reserve’s credibility was arguably less established, though we lack the data to confirm this hypothesis.
Figure 3. Decomposition of Far-Forward Nominal Rates
Notes: The thin black line depicts the sum of the PTR variable, labeled “pi-star” from the public variable file from FRB/US at the Federal Reserve Board website and median of the estimates of far-forward expected real short rates shown Figure 2. Data for pi-star for 2025:Q2-Q3 is imputed from the Survey of Professional Forecasters. The thick red line depicts the difference between the nominal 9-10 year forward rate and the sum, pi-star+r-star. The dotted blue line additionally subtracts off the inflation risk premium, measured as far-forward inflation compensation minus pi-star (see Figure 2).
of Governors, FRB-NY
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Why might far-forward real risk premiums have risen so significantly in recent years? As is standard in structural asset pricing literature, we assume investors demand compensation—in this case, higher far-forward rates—for risks to an investment position (long the 10-year Treasury and short the 9-year Treasury) that diminish the position’s value during poor economic states, such as a recession. One risk that fits these criteria is the threat of large adverse supply shocks, defined as shocks that simultaneously drive inflation up and weaken real economic activity. The inflationary pressure caused by these shocks may prompt the Fed to increase real short-term interest rates to stabilize inflation, which lowers the value of the forward investment position; furthermore, both the shocks themselves and the resulting monetary policy response could trigger recessions.
Moreover, the risk of adverse supply shocks may have recently increased. This is suggested by Engstrom’s (2025) estimates of adverse supply and demand shocks from 1971 to 2025, shown in the left panels of Figure 4. Under this methodology, adverse supply shocks are defined as those causing unexpectedly low real activity and high inflation, while negative demand shocks are those causing unexpectedly low real activity and low inflation. Engstrom finds that the recessions of the 1970s and early 1980s contained large supply shock components and no material demand-shock components, aligning with the conventional view that oil supply shocks fueled those downturns, whereas the subsequent four recessions featured large demand-shock components but no significant supply-shock components. He also finds that the 2020 recession involved both material adverse supply and demand shock components, which is intuitive given that the deep decline in activity was not accompanied by severe deflation (as would occur with a pure demand shock) or a historic inflation spike (as would occur with a pure supply shock). Additionally, he notes that adverse supply shocks occurred in 2021 and 2022, outside of a recession, but during a time of elevated recession risk.
Figure 4. Estimated Supply and Demand Shocks and Expected Shock Volatility
Notes: The panels on the left depict the estimated supply and demand shocks from Engstrom (2025). The panels on the right depict GARCH-based estimates of the expected volatility of supply and demand shocks. NBER-defined recessions are shaded in blue.
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Therefore, if investors base their expectations of the future on past experiences, we can plausibly conjecture that the risk of large adverse supply shocks (defined as the likelihood of shocks severe enough to cause recessions) increased with the 1975 and 1980 recessions, declined steadily throughout the four decades of demand-induced recessions that followed, and then rebounded somewhat in recent years with the pandemic-era recession and its aftermath. This narrative is supported by the upper right panel in Figure 4, which displays a model-based estimate of the predicted volatility of the supply shocks shown on the left. The model, which is of the GARCH class, maps the magnitude of recent supply shocks into a forecast for future supply shock volatility. The chart indicates that uncertainty regarding supply shocks peaked during the recessions of the late 1970s and 1980s, followed by a long, tranquil period of low volatility until 2020, when uncertainty surged again during the Covid recession and subsequent supply disruptions. Combined with the earlier finding that the far-forward inflation risk premium does not appear to have risen, the reemergence of supply shock risk as an asset pricing factor is somewhat surprising, as supply shocks have historically coincided with higher inflation. However, the steady level of the inflation risk premium is consistent with investors believing the Fed will quickly return inflation to its 2 percent target in the event of future supply shocks.
We also consider whether the risk of adverse demand shocks has declined recently, as this would also exert upward pressure on forward-rate premiums. A drop in demand shock risk would raise premiums by reducing the hedging value of the position against demand shocks—hedging value intuitively lowers the compensation investors require. Forward positions hedge against demand shocks because such shocks, when they occur, lead to lower interest rates in bad states of the world (e.g., when the Fed eases monetary policy to combat low inflation and weak economic activity). However, given that adverse demand shocks have been a reliable feature of recessions for the past several decades, according to Engstrom (2025), we have no evidence that the risk of adverse demand shocks has decreased. Indeed, the model-based predicted volatility of demand shocks, shown in the lower right panel of Figure 4, has increased materially in almost all recessions, notably during the GFC and Covid recessions.
The rise in far-forward rate premiums may also reflect an increase in perceived risks to far-forward rates linked to federal debt. As shown in Figure 5, the Congressional Budget Office’s projections for the debt-to-GDP ratio have risen markedly since 2015, with current forecasts indicating that debt is on track to continue rising rapidly, reaching nearly 120 percent of GDP in about a decade—surpassing the record high seen during World War II. Debt is measured relative to GDP as it serves as a rough proxy for the <a s debt-servicing capacity. Since these increasing projections have been publicly available, it is intuitive that concerns regarding future deficits may have grown. This implies an increasing risk that Treasury yields, including short-term yields, will need to rise in the future if investors begin to believe federal debt has become unsustainable. An increase in Treasury yields, particularly if driven by debt sustainability concerns, would likely raise borrowing costs across the economy, increasing recession risks. The reverse is also true: recessions tend to reduce the government's debt-servicing capacity, which could further exacerbate concerns about debt sustainability. This feedback loop suggests that far-forward positions in Treasury securities have become inherently riskier in recent years. From a structural asset pricing perspective, this increased risk should be reflected in higher risk premiums. Concerns about debt sustainability were also likely significant for asset pricing during World War II. Not only did the debt-to-GDP ratio reach historic highs in the 1940s, but the decision by the Treasury Department and Federal Reserve at that time to engage in a decade-long policy of yield curve control suggests that the risks to interest rates were material (see Rose, 2021). Notably, debt sustainability crises in other nations have historically led to inflation through subsequent drops in the value of their currencies. However, as discussed earlier, we see no evidence of a perceived increase in inflation risk in recent years.
Figure 5. Actual Debt-to-GDP and CBO Projection
Notes: The black line shows actual levels for U.S. Treasury debt held by the public as reported by the Congressional Budget Office (CBO). Also plotted are three vintages of CBO 10-year debt-to-GDP projections from 2015, 2020, and 2025 in green, blue, and red, respectively.
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In conclusion, a structural asset pricing perspective suggests that increases in the perceived risks of both adverse supply shocks and debt sustainability episodes plausibly explain the recent rise in far-forward interest rates. That said, the relative stability of inflation compensation suggests that investors maintain confidence in the FOMC’s ability to mitigate the extent to which the materialization of these risks leads to persistently higher inflation.
References
Bauer, Michael D., and Glenn D. Rudebusch. 2020. “Interest Rates under Falling Stars.” American Economic Review, 110 (5): 1316-54. DOI: 10.1257/aer.20171822.
Engstrom, Eric, C. 2025. “Soft Landing or Stagflation? A Framework for Estimating the Probabilities of Macro Scenarios,” Finance and Economic Discussion Series, Federal Reserve Board of Governors, 2025-047.
Fuhrer, Jeffrey C., Giovanni P. Olivei, and Geoffrey M. B. Tootell. 2012. “Inflation Dynamics When Inflation Is Near Zero.” Journal of Money, Credit and Banking 44 (February): 83–122
Gust, Christopher and Skaperdas, Arsenios. 2024. “Government Debt, Limited Foresight, and Longer-Term Interest Rates,” Finance and Economic Discussion Series, Federal Reserve Board of Governors 2024-27
Holston, K., Laubach, T., & Williams, J. C. 2017. “Measuring the natural rate of interest: International trends and determinants,” Journal of International Economics, 108(S1), S59-S75.
Rose, Jonathan. 2021, “Yield Curve Control in the United States, 1942 to 1951,” Economic Perspectives, Federal Reserve Bank of Chicago, October 2021 No. 2
1. The far-forward inflation risk premiums is calculated as the difference between inflation compensation and far-forward expected inflation (see Figure 2). We only have reliable measures of inflation compensation since the year 1999. TIPS were introduced in 1997 but were relatively illiquid for their first few years. We therefor only calculate a forward inflation risk premium from 1999, which implies we can only back out a forward real risk premium since 1999. Return to text
2. The supply and demand shocks are identified using structural vector auto regressions: In particular, Engstrom (2025) estimates the matrix of loadings that maps unobserved structural shocks (supply, demand, and other) to reduced-form shocks, by matching the variance-covariance matrix of the reduced-form shocks, while also employing intuitive sign restrictions on the effects of supply and demand shocks. This allows identification of the unobserved supply and demand shocks. Return to text
3. Recession fears were elevated at the time. According to the mean response from the Survey of Professional Forecasters, the probability of a decline in real GDP one quarter ahead peaked at 47 percent in 2022Q4, compared to a median historical level of 13 percent in data since 1968Q4. Return to text
4. Outside the structural asset pricing literature, behavioral models of preferred habitat also link deteriorating fiscal positions to rising term premiums on interest rates (see Gust and Skaperdas, 2024). Return to text
