An RSM model: What 5%, 5.5% and 6% yields mean for the economy

Ten-year Treasury yields continue to test at 5% because of risks around inflation, unsustainable deficits and a scarcity of both goods and capital amid the privately financed artificial intelligence build-out.

Under such conditions, we expect the 10-year Treasury yield will move decisively above 5% in the near term.

But how far will it go? Is 5.5% possible as shortages of oil and distillates out of the Middle East push inflation higher? Or, if inflation expectations increase as a result, is a move to 6% in the cards?

To understand what could happen, we modeled different yield scenarios and their impact on the economy. First we looked at growth, employment and inflation under the current 5% yield and then did the same under 5.5% and 6% yields should investors push long-term rates higher over the next year.

In those scenarios, the common trends are: Growth will slow below the 2% trend, unemployment will rise toward 5% and inflation will remain above 2%. Or, put simply, “stagflation lite” will set in. 

Whatever the case, central bankers are underestimating the heavy lift needed to achieve the Federal Reserve’s goal of bringing inflation down to its 2% target.

Our modeling that follows is aligned with the Fed’s most recent Summary of Economic Projections and its interest rate forecast, or dot plot, which implies one more rate hike this year and none next year.

While RSM forecasts that the Fed will lift rates by another 25 basis points this year and most likely again by 25 basis points early next year, whether we get one or two more hikes will not make a material difference in inflation. Either scenario will almost certainly prove necessary, but not sufficient, to achieve price stability anytime soon.

But further rate hikes will almost certainly be necessary, which will test how much economic pain the Fed will be willing to tolerate and could derail the extraordinary capital expenditure supercycle and the accompanying surge in equity valuations.

Given that the Fed does not project the economy to move back to 2% inflation until 2029, a period of immaculate disinflation, in which inflation declines without causing a major economic slowdown or a recession, will need to occur.

Such a scenario is not out of the question, as seen in an expectations-augmented Phillips curve, in which households and businesses believe that the Fed intends to move inflation back to 2% and then adjust their behavior accordingly.

But that scenario requires a lot to happen. Workers will need to ease their wage demands, and businesses will need to absorb higher input costs and accept thinner profit margins. Only then will the Phillips curve shift downward, with inflation easing back to the target without raising unemployment or bringing on below-trend growth.

Is that scenario possible? Yes, but it’s improbable based on our shock model and recent history.  

Unless oil prices fall sharply later this year or next, it is highly unlikely that conditions consistent with an expectations-augmented Phillips curve will coalesce. 

Model-derived outcomes

The 10-year Treasury yield crossed 5% on Sept. 14, a level it reached only briefly in October 2023 and last held for a full quarter in 2006.

Two days later, the Fed published a new projection, forecasting two more rate increases this year. In addition, eight of the 17 voting members of the Federal Open Market Committee forecast another 25 basis point rate hike next year.

The central bank has embarked on a rate-hike cycle—but will two hikes, or even three, be enough to push inflation back down to 2%?

We modeled a series of shocks through the rate channel to identify the impact on growth, employment and inflation. We then ran the Fed's FRB/US model based on a number of scenarios to estimate the impact on the economy.  

Our 2027 model-based projections

• The current increase to 5% in the 10-year yield shaves approximately 0.4 percentage point from gross domestic product over the next year. While it will not present a drag in the third quarter, that deadweight will likely result in slower growth in the final quarter of this year and throughout next year.
• An increase to 5.5% will shave two-thirds of a percentage point in GDP by the end of next year.
• An increase to 6% will result in the loss of nearly a full percentage point from GDP next year.
• Unemployment will end next year at 4.8% in the two worst-case scenarios, compared with 4.3% in the baseline forecast.
• Because the primary factor in rising long-term yields is inflation expectations, actual inflation will end next year higher in every scenario. As a result, the Fed will need to go beyond the two rate increases forecast in the Summary of Economic Projections or, more likely, beyond the three hikes that the market is pricing in.
  • The core personal consumption expenditures index, the Fed’s preferred inflation gauge, increases to 2.4% should the 10-year rise to 5.5%, versus the 2.2% baseline forecast.
  • With the funds rate fixed via the projection through next year, only an extremely unlikely immaculate disinflation could bring inflation back to the 2% target.  

The baseline

We built a counterfactual scenario to contrast with the current baseline—in which yields do not exceed 5%—to capture what would happen to growth, employment and inflation if the 10-year yield moves well above 5%.

To do that, we used data available before the third quarter and assumed the Fed would hold interest rates steady for the rest of this year. This was not only RSM’s forecast but also the overwhelming consensus before the third quarter.

In this baseline, at the end of 2027 the 10-year yield is expected to be around 4.5%, with growth at 2.2%, unemployment at 4.3% and core PCE inflation at 2.2%. 

The scenarios

In each scenario below, the Fed follows its projection (two hikes this year, none next year), and 50% of the yield's rise above the yardstick can be attributed to higher long-run inflation expectations as the 5-year and 30-year yields increase in line with the 10-year.

1. Increases to 5% and then holds near that level

Assumption: The 10-year reaches 5% in the third quarter with no material move higher.
Result: Third-quarter growth is unchanged at 2.4%; the economic drag arrives in the fourth quarter (minus 0.4 percentage point), and next year’s growth is 1.8% versus the previous forecast of 2.2%. Unemployment ends next year at 4.6%; payrolls average 51,000 a month; core PCE ends at 2.4%.

2. Increases to 5% and then fades back to 4.7%

Assumption: The 10-year moves to 5% in the third quarter, then fades the way past spikes have (keeping 50% of the rise after a year, 21% after two), to near 4.7% by the end of next year.
Result: Growth reaches only 1.9% next year, with unemployment at 4.5%, payrolls averaging 59,000 a month and core PCE at 2.3%. The difference between holding at the 5% level and fading back to near 4.7% shows up in 2028.

3. Increases to 5.5% in the fourth quarter and then fades

Assumption: The 10-year moves to 5% in the third quarter, increases to 5.5% in the fourth quarter and then fades as growth slows.
Result: Growth reaches only 1.5% next year—about a third of a point less than when the 10-year was 5%. Unemployment rises to 4.7% at the end of next year; payrolls average 33,000 a month. Core PCE ends next year at 2.4%; mortgage rates peak near 7.3%.

4. Increases to 6% in the fourth quarter and then fades

Assumption: This is similar to Scenario 3, with a 6% yield instead of 5.5% in the fourth quarter and a similar easing in market-derived longer-term rates as the economy slows.
Result: Growth slows to 1.3% next year; unemployment ends at 4.8; payrolls average 12,000 a month; core PCE ends at 2.6%. The 100 basis point increase roughly doubles the drag on growth.

5. Increases to 5.5% in the fourth quarter, rises to 6% in the first quarter and then fades to 5.7%

Assumption: The 10-year moves to 5% in the third quarter, 5.5% in the fourth quarter and 6% in the first quarter and then undergoes the same fade.
Result: The results are roughly the same as in Scenario 4 at the end of 2027 (growth of 1.3%, unemployment at 4.8%), but inflation expectations are 2.7%, the highest of any scenario.

Why the yield increase matters

We built 50% of every yield increase to include higher long-run inflation expectations.

In the model, the expectations component of the 5.5% case lifts the 10-year 36 basis points on its own at once and an additional 18 basis points by the end of next year; the term premium supplies the rest.

How long a spike lasts

Our fading paths follow the six episodes since 1990 in which the 10-year yield rose at least three-quarters of a point in six months—1994, 1996, 2000, 2014, 2018 and 2022. On average, the yield gave back half the rise within three quarters and most of it within two years; only in 2022 did it keep climbing. The size of the yield increase will determine the damage in 2027; the duration of the increase will determine the impact in 2028.

Bottom line

Market-determined long-term rates have moved higher, and 5% is where the 10-year benchmark yield now resides. Together with the Fed's two hikes, it will shave approximately 0.4 percentage point from growth over the coming year. A move to 5.5% will increase that cost by an additional one-third of a point and result in a slower pace of hiring and rising unemployment.  

What the yield does to inflation depends on why it is rising: If the market is pricing in inflation, it gets inflation. That is how inflation expectations work, and the Fed will need to lift rates higher than its current forecast to bring inflation back toward its target.

Methodology

We used the Federal Reserve Board's FRB/US model to compare alternative 10-year Treasury yield paths against a baseline forecast built from data available through the second quarter of 2026.

Each scenario applies the Fed's September policy projection and then isolates the effect of different yield levels and persistence assumptions. The yield paths move the broader Treasury curve with the 10-year yield, and part of each increase is treated as higher long-run inflation expectations to reflect the market's interpretation of the move.