Higher Interest Rates Maybe Forever - rising ‘neutral rate’

The consensus view at the US Federal Reserve, the European Central Bank and the Bank of England is that the Wicksellian “natural” rate of interest – known as R* – has jumped to a permanently higher level.

Philip Turner, a former top official at the Bank for International Settlements, and Marina Misev from the University of Basel, warn that central banks are being misled by false assumptions about R* into dangerous overtightening, risking a global credit crunch and an asset crash.

Ambrose Evans-Pritchard Telegraph 14 November 2023

Englund: The world economy has been kept afloat for a quarter century by serial bubbles. Ambrose and R* (englundmacro.blogspot.com)

In more technical terms, the so-called neutral rate, which keeps inflation and unemployment stable over time, has risen.

This matters to any investor, business or household whose plans depend on interest rates over a decade or longer. It could explain why long-term Treasury yields have risen sharply in the past few months, and why stocks are struggling.

The neutral rate isn’t literally forever, but that captures the general idea. In the long run neutral is a function of very slow moving forces: demographics, the global demand for capital, the level of government debt and investors’ assessments of inflation and growth risks.

The neutral rate can’t be observed, only inferred by how the economy responds to particular levels of interest rates. If current rates aren’t slowing demand or inflation, then neutral must be higher and monetary policy isn’t tight.

Before the 2007-09 recession and financial crisis, economists thought the neutral rate was around 4% to 4.5%. After subtracting 2% inflation, the real neutral rate was 2% to 2.5%. 

Federal debt now stands at 95% of gross domestic product, up from 80% at the start of 2020, and federal deficits are now 6% of GDP

Indeed, futures markets peg rates a decade from now at around 3.75%.

For now, the evidence suggests the public should get used to higher rates as far as the eye can see.

Greg Ip WSJ 21 September 2023


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