Written by Jörg Baselli
(Reuters) – If financial markets are right, interest rates will remain high not just this year, but perhaps forever.
A return to inflation means ultra-low interest rates are a thing of the past. And economists say markets are now reflecting a scenario in which even the neutral interest rate, which balances the economy over the long run after accounting for inflation (known as R-star), is rising.
Traders expect U.S. interest rates to be around 4% by the end of the decade, far higher than policymakers’ long-term expectations of 2.6%. Interest rates in the euro area are expected to be around 2.5%, higher than the rates that have prevailed for most of the euro area’s history.
However, correctly determining where interest rates will stabilize is a major challenge for policymakers and investors. Many economists think the R-star is lower than it was before the Great Financial Crisis, but they disagree on how it is calculated, its current level, and whether it is rising. .
Shamik Dhar, chief economist at BNY Mellon Investment Management, said he believes the rise in R-star stocks is “nervous because it’s not fully priced into the stock market and the real estate market.”
We consider five factors that determine long-term interest rates.
1/ Enforcement of the bill
Government borrowing, whether for climate change or the military, will remain high due to huge investment needs and rising interest costs.
Economists debate the effects of rising debt, but some expect spending demands to cause interest rates to rise.
According to IMF estimates, the budget deficit in developed countries will be 5.6% of output in 2023, almost double the 3% in 2019, and will remain high in 2029 at 3.6%.
Ed Hutchings, head of rates at Aviva Investors, said a widening budget deficit would increase premium investors’ demand for holding government bonds.
But on both sides of the Atlantic, productivity growth has slowed, constraining potential growth, and economists say these factors are holding back investment.
“If that happens, there will be fewer increases in the neutral policy rate,” said Idanna Appio, a former Fed economist and portfolio manager at First Eagle Investment Management.
2/older
Dahl, a former Bank of England economist at BNY Mellon, said demographics are one of the biggest uncertainties facing long-term interest rates.
There is a consensus that a glut of pre-retirement savings in rich countries is pushing down interest rates.
It may continue. United Nations plans predict that 16% of the world’s population will be over 65 years old by 2050, up from 10% in 2022. It is probably felt most strongly in Europe.
However, the ratio of dependents, including retirees, to workers is increasing. Economists Charles Goodhart and Manoj Pradhan argue that age-related spending will reduce savings and raise interest rates.
Nomura said covering pension shortfalls through borrowing would also put upward pressure on interest rates.
3/ Heat up
Measuring the economic impact of climate change is also a major challenge.
The European Central Bank’s Isabel Schnabel said the green transition would require huge investments that would lead to higher interest rates, comparing it to the scale needed to rebuild Europe after World War II.
The physical effects of climate change also lead to the risk of higher inflation and price fluctuations.
However, global production could be cut by up to 17% by 2050. This damage could threaten productivity and depress R-stars, the ECB paper argues.
Higher clean energy prices could ultimately reduce investment demand and, in turn, lower interest rates, the IMF said.
Soren Rade, head of European economic research at hedge fund Point72, said it was a “huge public debate” about the impact of climate change on interest rates.
“We’re seeing a negative shock that essentially destroys demand. It’s not clear whether that’s going to lift the R-star,” he said.
4/AI Mania
The extent to which technological revolutions will improve productivity and rates is hotly debated.
Goldman Sachs predicts that productivity gains from AI could add 0.4 percentage points to U.S. economic growth and 0.3 percentage points to other developed countries by 2034. The company believes that there will be upward pressure on interest rates, especially if the introduction of AI is brought forward.
If the impact of AI is comparable to that of electricity, Vanguard believes growth will offset demographic pressures. However, you may be disappointed if it is the same as computers and the Internet.
5/ New reality
The COVID-19 pandemic, wars in Ukraine and Gaza, and trade tensions between the U.S. and China raise the risk of future supply shocks.
“If central banks have to counter them, the level of interest rates could rise on average,” Point72’s Rade said.
“Friendshoring,” in which Western countries and companies seek to increase trade with allies rather than China, also poses a risk of rising interest rates.
“They’re all going to be inflationary because they’re not the cheapest producers,” said Roman Geyser, head of fixed income at Columbia Threadneedle.
For example, Mexico is currently the largest source of imports for the United States.
(Reporting by Yoruk Bahceli; Additional reporting by Naomi Rovnick; Editing by Gavin Jones, Dhara Ranasinghe and Christina Fincher)
