In the vast economic arena, the cost of money eclipses the price of oil or semiconductors in importance. Once on a downward trend for over thirty years, it’s now ascending, shifting the economic dynamics worldwide. While the Federal Reserve has significant control over U.S. interest rates, the actual setting of these rates is a more complex interplay of savings and investment demand.
Known among economists as the “natural rate of interest,” this cost of money is pivotal for economic stability. Should the Federal Reserve set rates below this natural rate, an overheated economy with high inflation could ensue. Conversely, too high rates could lead to increased unemployment due to a slowdown in investment.
Our analysis shows a steady decline in the natural rate, from over 5% in the 1980s to less than 2% in the last decade, when adjusted for inflation. To predict future movements and understand past trends, we’ve constructed a model reflecting the significant factors influencing savings and investment across 12 major economies over the past fifty years.
Reduced economic growth since the 2000s, exacerbated by the 2007-08 financial crisis, is a primary reason for the lower natural rate. Additionally, demographic shifts, like the retirement preparations of baby boomers, have increased savings, exerting downward pressure on rates. Technological advancements leading to cost-effective investments and significant saving injections from high earners and fast-growing economies like China have also played their roles.
These factors led to an era of cheap borrowing, resulting in larger household mortgages and significant government spending despite the growing federal debt. However, the retirement of baby boomers, a shift in China’s economic policies, and the increasing U.S. debt suggest a reversal, with long-term borrowing costs already on the rise.
Our projections, using a vector autoregressive model, anticipate an increase in the natural rate of about one percentage point by 2050, which could translate to Treasury yields between 4.5% and 5%. But should government deficits continue, or investments to combat climate change surge, we could see even higher rates.
As the natural rate begins its ascent, we’re likely to witness the end of surging house prices and the tempering of equity market growth. The federal government will face higher debt servicing costs, with every percentage point rise in interest rates potentially adding 2% of GDP to the annual cost.
Nevertheless, there are upsides to higher rates. Savers and bond investors will enjoy improved returns, and the Federal Reserve will regain some leverage to influence growth during downturns. As this shift unfolds, the economic landscape will undoubtedly change, affecting everything from real estate to investment portfolios to government budgets.
Our methodology for forecasting the natural rate is rooted in fundamental economic factors, with the belief that borrowing costs will converge with the natural rate over time. The focus on long-term rates is strategic, given their impact on the economy and their benchmark status in global finance.
