Are higher interest rates here to stay?

Over the past 18 months, interest rates have risen dramatically in the United States and abroad as central banks remain committed to taming the surge in inflation following the pandemic and war in Ukraine. Despite recent positive inflation developments and prospects for interest rate normalization, economic journalists and commentators are wondering whether the post-pandemic world will see a return to low interest rates. Former Treasury Secretary Lawrence Summers recently warned that interest rates on Treasury bills could remain well above 3 percent through 2030, after averaging only 1.5 percent in the last decade. Harvard economist Kenneth Rogoff declared in December that “higher interest rates are here to stay.”

The longer-run outlook of the Federal Open Market Committee, or FOMC (the seven Fed governors and 12 Reserve Bank presidents), also reflects a shift toward a somewhat higher interest rate as a new norm. As shown in the left panel of Figure 1, in the December 2019 Summary of Economic Projections, FOMC members were tightly clustered around a median nominal, longer-run rate of 2.5 percent (the Fed’s target of 2 percent annual inflation plus a 0.5 percent real interest rate). In the latest read-out from December 2023 (right panel of Figure 1), the median was still 2.5 percent, but the dots skew notably higher, with three participants expecting a longer-run interest rate of at least 3.5 percent.

The dispersion in these projections suggests a great deal of uncertainty around the level of interest rates in the long run. After all, the United States and economies around the world are still recovering from the disruptions of the pandemic and the war. For instance, the implications of changes in working arrangements—such as a more common adoption of work-from-home practices—and reconfigurations of global value chains to increase production resilience have yet to fully play out.

Against this backdrop, here we attempt to provide a case that interest rates may well return to the low levels observed in the pre-pandemic years once inflation sustainably returns toward central banks’ targets. Our main argument is that the fundamental factors driving down interest rates in recent decades—slowing productivity growth and aging demographics—are likely to continue to exert downward pressure on interest rates going forward. A possible countervailing factor—higher government debt—does not seem sufficient to outweigh them.

Tracing the path of “R-star”

The economy’s equilibrium, neutral interest rate is known by economists as “R-star.”¹ R-star is neutral in the sense that it is the short-term rate of interest at which the economy is at full employment and inflation has stabilized at the target rate. The level of R-star is a key factor determining interest rates faced by consumers, businesses, and governments.

R-star is also an essential concept for monetary policy. When the Federal Reserve targets a short-term interest rate that is higher than R-star, it intends to impart a restrictive policy stance on the economy. In January, for instance, the FOMC kept the federal funds rate in the range between 5.25 and 5.5 percent, well above the median projected longer-run value of 2.5 percent, to ensure that demand and supply come into better balance and, ultimately, inflation returns to the 2 percent target.²

R-star is a theoretical interest rate that cannot be directly observed. Economists and financial market participants have pursued several approaches to assess the level of R-star. Some rely on econometric estimates from financial market data, often integrated with information from surveys. Others make use of dynamic stochastic general equilibrium models to trace out the changes in R-star from macroeconomic and financial data.

Although estimates differ across approaches, the consensus is that real (after inflation) R-star declined significantly between 1960 and 2020. For instance, according to the Holston-Laubach-Williams (HLW) model maintained by the New York Fed (Figure 2), R-star was near 5 percent in the 1960s, fell steadily in subsequent decades (except for a brief surge in the late 1990s) and plummeted during the Great Recession of 2007–2009.

After the Great Recession, R-star remained generally below 1 percent until the COVID-19 pandemic. All told, the HLW model finds that R-star has declined roughly 4 percentage points since the 1960s, a decline consistent with other estimates.

Extending the era of low productivity growth

The long-run real interest rate is the rate at which the demand for investment is in balance with the supply of savings. If new technologies or other factors drive up productivity (the ability to produce more with less), this change will boost economic growth and increase the demand for funds for investment, driving up interest rates. Thus, economic theory suggests economies that are growing faster because of higher productivity should experience higher interest rates.

Productivity growth has fallen to historically low levels in the postwar years. According to a measure of total factor productivity calculated by the San Francisco Fed, the American economy has experienced a steady decline in productivity growth since the 1960s, except for a brief surge in the 1990s when the explosion in processing power and widespread adoption of computing contributed to high productivity gains (Figure 3). Between 2003 and 2019, U.S. productivity growth averaged a meager 0.6 percent. Similar trends are present in other countries.

Estimates of productivity growth since 2020 (the rightmost bar in Figure 3) suggest that the current environment might not be that different from recent decades. That said, the economy has experienced some exceptional developments in recent years and the future may be brighter. Advances in artificial intelligence (AI), for example, have sparked speculation that we are on the verge of a new productivity boom. A bold prediction from Goldman Sachs suggests AI will add 1.5 percentage points to annual U.S. productivity growth during the next decade.

While it is possible that AI will beget a repeat of the 1990s, history also has plenty of examples of technological advances that changed our lives—consider smartphones or social media—without meaningfully raising overall economic productivity.

Overwhelming demographic shifts

The consensus in the academic literature seems to be that demographic factors—such as declining population growth and longer lifespans—account for the bulk of the estimated 4-percentage-point drop in R-star.³ U.S. population growth has fallen below 0.5 percent a year in the last decade and is expected to decline further (Figure 4). In addition, the lifespan of an average U.S. child at birth is projected to exceed 80 years by 2030 (Figure 5). In other advanced economies, such as Japan and Europe, these trends have been underway for decades and are expected to continue, despite the short pandemic-related interruption.

These demographic shifts are also projected to take place in emerging market economies, possibly adding to the global downward pressure on interest rates. A 2021 study by Auclert, Malmberg, Martenet, and Rognlie, for instance, estimates that the aging world population will result in an additional 125 basis point reduction in interest rates through the end of the century.

Like productivity growth, slowing population growth reduces the growth rate of the economy and thus the demand for investment. At the same time, people are increasing their savings as they prepare for longer lifespans. Research from the Minneapolis Fed’s Opportunity & Inclusive Growth Institute finds older Americans continue saving well into retirement, anticipating high end-of-life costs and to leave bequests if those funds are not needed.

More savings—and lower demand for those savings for investment—puts downward pressure on interest rates. Demographic changes are like the metaphorical aircraft carrier: They change course slowly, if they change at all. This carrier does not seem to be turning.

What about the national debt?

The United States increased federal borrowing during the pandemic to finance support programs for households and firms. The federal debt held by the public was 97 percent of GDP in 2023, 18 percentage points higher than in 2019 (Figure 6). Other countries adopted a similar response to pandemic disruptions. Many commentators have argued that higher public debt levels will necessarily result in much higher interest rates.⁴

The effects of higher debt levels on interest rates depend on, among other factors, the balance between demand and supply of safe assets. Unlike private assets, public debt is a special asset for the economy in that it preserves its value during times of distress, when it is perceived as safe.⁵ From this perspective, U.S. debt has the advantage of remaining the preferred safe asset around the globe. This is thanks to U.S. fiscal capacity, the high level of development of the U.S. financial system, and the strong credibility of the Federal Reserve System.

Will the recent increase in U.S. public debt jeopardize its status of preferred safe asset? It seems unlikely. As shown in Figure 6, U.S. federal debt doubled between 2005 and 2019 in the aftermath of the global financial crisis, but interest rates remained very low. Relative to that episode, the pandemic-induced rise in public debt appears small. While higher debt levels should push upward on interest rates, quantitatively this effect may turn out to be small when compared with other developments affecting the demand for safety and, more generally, the neutral interest rate.⁶ Indeed, many high-growth and high-saving emerging economies do not have access to domestic safe assets and are likely to continue to use U.S. debt as their main risk-free savings vehicle.⁷

Two caveats are important. First, the United States cannot take the status of preferred global safe asset for granted. Under current policies, the U.S. federal debt held by the public will reach 126 percent of GDP by 2040, according to recent projections. Excessively elevated public debt levels may call into question the perception of safety. Second, the unexpected surge of inflation since 2021 has demonstrated that, in some circumstances, public debt does not preserve value in times of distress. The extent to which investors will require compensation for this risk—and thus higher interest rates—will depend on the frequency of similar episodes in the future.

Will interest rates stay high?

The physicist Niels Bohr is credited with saying, “Prediction is very difficult, especially about the future.” The next pandemic—or the next war or other global event—can shock our national and global economies, altering the interest rate environment and much more.

The data before us today, however, suggest caution in embracing the prediction that interest rates will be higher in the long run. The factors that contributed to the decline in the neutral rate between 1960 and 2020—weak productivity growth and global demographic shifts—look like they are here to stay.

Endnotes

1 For a detailed discussion about the concept of R-star, see the October 2015 FOMC staff memos.

2 Fed Chair Jerome Powell provided a clear characterization of the stance of monetary policy along these lines at the November 2023 post-FOMC press conference.

3 See, for instance, Carvalho et al. (2016), Eggertsson et al. (2019), and Gagnon et al. (2021).

4 “It is becoming increasingly clear that a return to the post-2008 era of interest rates close to zero percent is unlikely,” wrote the Financial Times in November. “The longer-term outlook for rates is highly contested, but factors that could keep them up include high levels of public borrowing.”

5 For an extended discussion of public debt as a safe asset, see Caballero et al. (2017).

6 Estimates by Ferreira and Shousha (2023) on the sensitivity of neutral interest rates to the global supply of safe assets confirm this intuition.

7 Former Fed Chair Ben Bernanke put forward the “global saving glut” hypothesis in 2005, and academic literature has subsequently supported it, such as Caballero et al. (2008) and Mendoza et al. (2009).

References

Auclert, Adrien, Hannes Malmberg, Frédéric Martenet, and Matthew Rognlie. 2021. “Demographics, Wealth, and Global Imbalances in the Twenty-First Century.” Working Paper 29161, National Bureau of Economic Research.

Bernanke, Ben. 2005. “The Global Saving Glut and the U.S. Current Account.” Lecture presented at the Sandridge Lecture. Virginia Association of Economists, Richmond, VA.

Caballero, Ricardo J., Emmanuel Farhi, and Pierre-Olivier Gourinchas. 2008. “An Equilibrium Model of ‘Global Imbalances’ and Low Interest Rates.” American Economic Review 98(1): 358-93. doi:10.1257/aer.98.1.358.

Caballero, Ricardo J., Emmanuel Farhi, and Pierre-Olivier Gourinchas. 2017. “The Safe Assets Shortage Conundrum.” Journal of Economic Perspectives 31(3): 29–46. doi:10.1257/jep.31.3.29.

Carvalho, Carlos, Andrea Ferrero, and Fernanda Nechio. 2016. “Demographics and real interest rates: Inspecting the mechanism.” European Economic Review 88: 208–226. doi:10.1016/j.euroecorev.2016.04.002.

Eggertsson, Gauti B., Neil R. Mehrotra, and Jacob A. Robbins. 2019. “A Model of Secular Stagnation: Theory and Quantitative Evaluation.” American Economic Journal: Macroeconomics 11(1): 1–48. doi:10.1257/mac.20170367.

Ferreira, Thiago, and Samer Shousha. 2023. “Determinants of global neutral interest rates.” Journal of International Economics 145(C). doi:10.1016/j.jinteco.2023.103833.

Gagnon, Etienne, Benjamin K. Johannsen, and David López-Salido. 2021. “Understanding the New Normal: The Role of Demographics.” IMF Economic Review 69: 357–390. doi:10.1057/s41308-021-00138-4.

Mendoza, Enrique G., Vincenzo Quadrini, and José-Víctor Ríos-Rull. 2009. “Financial Integration, Financial Development, and Global Imbalances.” Journal of Political Economy 117(3). doi:10.1086/599706.