Whither Real Interest Rates for the next 30 Years?

A new blog from the IMF came my way and it looked interesting: Interest Rates Likely to Return Toward Pre-Pandemic Levels When Inflation is Tamed.  The blog refers to some research from the IMF that looks at the long term drivers of long-term interest rates.  Unless you have been sleeping under a rock for 30 years, you know that the global economy has experienced slowing declining interest rates.  The last few years, since the Great Financial Crisis and Covid have seen rates get throttled, or even pushed below zero.  The IMF blog has a chart showing this trend.

The blog reports: “To investigate this issue in more depth, we use a detailed structural model to identify the most important forces that can explain comovement in natural rates over the past 40 years. On top of global forces that impact net capital flows, we find that total factor productivity growth (the total amount of output produced with all factor inputs in the economy) and demographic forces, such as changes in fertility and mortality rates or time spent in retirement, are major drivers of the decline in natural rates.”

The truth we know

This rings a bell.  I found The Great Demographic Reversal, by Charles Goodhart and Manoj Pradhan, enlightening.  Demographics do seem to be at play over the long haul.  China joined the WTO in 2001 lowering, at a stroke, global wages.  The unification of Germany (Belin Wall, 1989) helped lower wages in Europe.  Other research also shows how populations have been growing over the last 30-40 years.

I continue to study productivity too.  Global Productivity – Trends, Drivers, and Polices, from the World Bank Group, suggests that productivity is in the tank.  It has been declining or flat for 20-30 years, depending on what metrics you use.  Despite all our efforts with training and technology, the data suggests we are now more productive.  Our economies are larger, for sure, but work and production are quire different to productivity.  An email is an email is an email, whether you are sitting in the bathroom, on a plane, or at your desk.

The IMF blog then also states: “Higher fiscal financing needs have pushed up real rates in some countries, like in Japan and Brazil.”  This I get.  Fiscal financing needs is now a universal challenge.  The US has a problem since its fiscal policy is to increase debt and spending, just as its monetary policy seeks to tighten and slow down growth.  The EU and UK is not that different.  But these issues drive up rates.

A Disagreement?

And then the IMF loses me with this: “These factors are not likely to behave very differently in the future, so natural rates in advanced economies will likely remain low.”  This I do not get at all.

• Demography has flipped (UN).  Working populations are now declining in most industrial regions.  China will no longer drive wages lower; it will soon start to drive wages higher, and for a long time.  Populations are aging, and they will demand more healthcare, and consume their savings in retirements.  This savings ratio will fall, and need for taxation will rise just as fewer people pay taxes.
• Productivity is not changing, at least not yet.  We are all ever hopefully.  I just blogged last week that generative AI might well be the change we were all looking for.  But that is a big ask and it will take more than that to change global productivity.

So for me, three trends will converge and drive long term rates up.  How can they remain low?  What demographic trend lowers costs ?  What productivity trend creates growth?  What fiscal policy declines due to lower public sector needs?  I can’t see any.

Keep your eye on the ball

Interest rates are important.  The higher they are, the better capital allocation behaves.  Or put another way, decision making works as we all know and love from business school.  When rates are below zero, decision making is messed up.  But as rates go up, returns on capital increase, and so your ROI promises for that next big IT, digital or AI project, has to grow too.   Who would pay for a 2 year project that promises 5% if I can get 7% with financial investments?  This is why demographics and productivity are so interesting.  It changes everything, eventually.