Where do natural interest rates go? – 06/19/2023 – Why? Economês in good Portuguese

The “perfect storm” that fell on the global economy from 2020 onwards —the combination of the pandemic, the invasion of Ukraine, and more intense and frequent adverse weather phenomena—, accompanied by aggressive countercyclical fiscal and monetary policies in response, brought about lasting changes in the regime macroeconomics of advanced economies. In the 12 years following the 2008-09 global financial crisis, low inflation and interest rates prevailed, as did the abundance of liquidity provided by central banks. As of 2021, we witnessed a sharp rise in inflation rates, which exhibited some downward resistance despite the significant increase in interest rates and the beginning of policies to reduce central bank balance sheets (the “quantitative tightening”) since the year past.

The question arises: how durable will this change in the macroeconomic regime be? After the moment of monetary tightening and consequent inflationary stabilization at lower levels, in two years or more will interest rates in advanced economies return to levels as low as those of recent decades? Or has something fundamental changed, increasing the frequency of price shocks and the need for higher interest rates?

For economists, this question amounts to “where do ‘natural’ interest rates go?” The “natural” interest rate in an economy is the one over which, under current conditions, there are no inflationary or deflationary pressures, that is, inflation is stable and the economy’s product corresponds to its potential. It is the rate at which aggregate demand equals aggregate supply, which is to say, unconsumed income equals investment demand.

It is not something directly observable and the most that is sought is to estimate it as a latent variable, based on data and models with hypotheses. It is also something that is used as a reference for the medium and long term, that is, beyond cyclical fluctuations in the economy.

The natural interest rate, in real terms, constitutes a kind of reference anchor for monetary policy. In effect, when added to the rate that corresponds to the inflation target pursued by the Central Bank, there is a nominal interest rate at which the Central Bank would be happy with the inflation rate and would not be propelling or decelerating economic activity beyond or below its potential pace.

This natural interest rate would reflect structural factors that command aggregate supply and demand. The natural rate changes over time as these structural factors that operate as a gravitational anchor evolve.

Well then. Why have natural interest rates steadily declined over the last few decades in developed economies? What structural factors on the real side of the economy led them in that direction? Four are often singled out – three on the savings side and one on the investment side.

First, demography and an aging population. Given the evolution of age pyramids, large portions of the populations of advanced economies have gone through the intensive phase of saving their lives. This boosted global savings and lowered real interest rates. In addition, rising life expectancy has led these people to save even more for longer retirements.

The increase in income and wealth inequality was another structural factor, since the greater holding of resources by richer families tended to increase the volume of savings, putting downward pressure on interest rates. A third structural factor was the rise of non-advanced economies —especially China— with high savings rates and interested in keeping part of their —official or private— wealth reserves in assets considered safer, in advanced economies.

A fourth factor comes from the investment side. A surprising trend in the years leading up to the “perfect storm” was the persistence of low levels of investment in advanced economies despite the large drop in real interest rates. Hypotheses about this are generally associated with technological evolution: the new fronts of advancement so far have not driven productivity and/or accumulation of physical assets like the previous ones.

The mismatch between the demand for assets due to growing savings and the low incorporation of new real assets even gave rise to a strong demand for –and valuation– of existing assets, giving rise to what we call a “macroeconomy led by asset bubbles”.

Taking those structural factors into account, among others, it is therefore not surprising that the International Monetary Fund (IMF), in the second chapter of its April “World Economic Outlook” report, concluded that long-term forces point to the return of natural interest rates in advanced economies to low levels. After, of course, inflation is brought back in the next few years, during which higher interest rates will be present. Assuming also that the inflation expectations of economic agents do not abandon their anchors at lower levels.

The current macroeconomic regime change with regard to inflation and interest rates would then be temporary. The IMF report alludes to the possibility of even returning to “unconventional” monetary policies, such as those adopted when interest rates tended to move towards negative levels in real terms.

There are factors often suggested as pointing in the opposite direction, with regard to inflation or, at the very least, recurring price shocks. The energy transition will tend to bring price shocks.

Partial “deglobalization” will also bring inefficiency and cost shocks, whereas globalization has helped to keep inflation low in advanced economies in past decades. There are, on the other hand, good reasons to believe that such shocks –upwards and downwards– were never significant enough to dictate the evolution of inflation and interest rates.

Therefore, a return to normal of lower interest rates in advanced economies is to be expected. According to the IMF report, although the set of emerging and developing economies did not follow the advances in the reduction of natural interest rates in the period before the “perfect storm”, their demographic trends, productivity and technology would also point in this downward direction in the future.

Otaviano Canuto was Vice President and Executive Director at the World Bank, Executive Director at the IMF and Vice President at the IDB. He was also secretary of international affairs at the Ministry of Finance and professor at USP and Unicamp. He is currently a senior fellow at the Policy Center for the New South, a non-resident senior fellow at the Brookings Institution, and a professor at the Elliott School of International Affairs at George Washington University.

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