According to recent market trends, there is a growing belief that interest rates may not only stay high in the near future but potentially remain so permanently. This shift is largely due to the return of inflation, which has signaled the end of ultra-low interest rates. Financial markets indicate that U.S. interest rates could reach around 4% by the end of the decade, while euro area rates are projected to rise above historical averages. However, determining where rates ultimately settle remains a significant challenge for policymakers and investors, as many economists contend that the neutral interest rate, known as ‘R-star,’ is increasing but differ in their calculations, interpretations, and assessments regarding its current level and trajectory.
One factor that will influence interest rates in the long term involves substantial investment requirements, whether related to climate change or defense expenditures. These investments will contribute to ongoing government borrowing, and economists predict that such debt levels will result in higher premiums demanded by bondholders. While some experts suggest that increased spending demands may drive rates higher, others suggest that lower productivity gains and sluggish economic growth will lead to less significant increases in interest rates.
Demographics represent yet another critical uncertainty concerning longer-term interest rates. As the global population ages, it will become increasingly evident, particularly in Europe, where the UN anticipates that 16% of the world’s population will be over sixty-five by 2050. With a growing proportion of dependent individuals, including retirees, to working-age people, age-related expenses will contribute to rising interest rates, according to analyses by economists Charles Goodhart and Manoj Pradhan. Pension shortfalls could further fuel upward pressure on rates if resolved via borrowing.
Climate change represents another significant unknown when forecasting longer-term interest rates. Although the transition to green technologies necessitates massive investment, the European Central Bank’s Isabel Schnabel has compared the magnitude required to that seen during post-World War II reconstruction efforts. Nonetheless, the actual economic effects of climate change remain uncertain. Some analysts argue that climate change could decrease global output by as much as 17% by 2050, leading to lower R-star values due to reduced productivity levels. On the other hand, the costliness of clean energy may eventually reduce investment demand and rates, as suggested by the International Monetary Fund (IMF).
The technological revolution’s extent and effect on productivity and interest rates are subjects of intense debate. Goldman Sachs predicts that artificial intelligence (AI) might enhance U.S. economic development by 0.4 percentage points and 0.3 points in other advanced economies by 2034. Such developments could result in increased demand and upward pressure on rates, especially if AI adoption occurs prematurely. Still, some experts caution that AI’s impact might fall short of previous technological breakthroughs, such as electricity and the internet.
Lastly, heightened supply-shock risks stemming from events like the COVID-19 pandemic, conflicts, and trade disputations between the US and China could lead to higher interest rates if central banks feel compelled to intervene. Additionally, the trend of “friendshoring,” or Western countries and businesses trading more among themselves instead of China, might result in greater inflationary pressures due to higher production costs, according to Columbia Threadneedle’s Head of Fixed Income Roman Gaiser. Mexico presently ranks as the largest supplier of goods to the US.
In summary, several factors will influence interest rates in the long term, including substantial investment requirements, demographic shifts, the impact of climate change, technological advancements, and geopolitical disruptions. Policymakers and investors must carefully weigh these variables and make informed decisions regarding where rates will settle.
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