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In March 2020, the U.S. Federal Reserve cut already depressed interest rates to historic lows amid an unraveling COVID-19 pandemic.

Fast-forward to 2022, and the central bank is grappling with a very different economic situation⁠ that includes high inflation, low unemployment, and increasing wage growth. Given these conditions, it raised interest rates to 2.25% up from 0% in just five months.

As Visual Capitalist shows in the animation by Jan Varsava shows U.S. interest rates over the last two years along with its impact on Treasury yields, often considered a key indicator for the economy.

Timeline of Interest Rates

Below, we show how U.S. interest rates have changed over the course of the pandemic:

In early 2020, the Federal Reserve cut interest rates from 1% to 0% in emergency meetings. The U.S. economy then jumped back from its shortest recession ever recorded, partially supported by massive policy stimulus.

But by 2022, as the inflation rate hit 40-year highs, the central bank had to make its first rate increase in over two years. During the following Federal Reserve meetings, interest rates were then hiked 50 basis points, and then 75 basis points two times shortly after.

Despite these efforts to rein in inflation, price pressures remain high. The war in Ukraine, supply disruptions, and rising demand all contribute to higher prices, along with increasing public-debt loads. In fact, a Federal Reserve estimate suggests that inflation was 2.5% higher due to the $1.9 trillion stimulus, an effect of “fiscal inflation.”

Impact on the Treasury Yield Curve

The sharp rise in interest rates has sent shockwaves through markets. The S&P 500 Index has steadily declined 19% year-to-date, and the NASDAQ Composite Index has fallen over 27%.

Bond markets are also showing signs of uncertainty, with the 10-year minus 2-year Treasury yield curve acting as a prime example. This yield curve subtracts the return on short-term government bonds from long-term government bonds.

When long-term bond yields are lower than short-term yields—in other words, the yield curve inverts—it indicates that markets predict slower future growth. In recent history, the yield curve inverting has often signaled a recession. The table below shows periods of yield curve inversions for one month or more since 1978.

For example, the yield curve inverted in February 2000 to a bottom of -51 basis points difference between the 10-year Treasury yield and the 2-year Treasury yield. In March 2001, the U.S. economy went into recession as the Dotcom Bubble burst.

More recently, the yield curve has inverted to its steepest level in two decades.

This trend is extending to other countries as well. Both New Zealand and the UK’s yield curves inverted in August. In Australia, the yield spread between 3-year and 10-year bond futures—its primary measure—was at its narrowest in a decade.

What’s On the Horizon?

Sustained Treasury yield inversions have sometimes occurred after tightening monetary policy.

In both 1980 and 2000, the Federal Reserve increased interest rates to fight inflation. For instance, when interest rates jumped to 20% in 1981 under Federal Reserve Chairman Paul Volcker, the U.S. Treasury yield inverted over 150 basis points.

This suggests that monetary policy can have a large impact on the direction of the yield curve. That’s because short-term interest rates rise when the central bank raises interest rates to combat inflation.

On the flip side, long-term bonds like the 10-year Treasury yield can be affected by growth prospects and market sentiment. If growth expectations are low and market uncertainty is high, it may cause yields to fall. Taken together, whether or not the economy could be headed for a recession remains unclear.