Both the actual rate and the neutral rate—the theoretical policy rate that encourages neither faster nor slower economic growth but supports the status quo—will rise, said Alexis Gray, Vanguard’s senior economist in Melbourne and one of three authors of a recent research paper on the topic.
“But people shouldn’t confuse neutral rates with actual interest rates,” Gray said. “Many major economies are in the midst of a rate-hiking cycle, with interest rates going from below equilibrium to above equilibrium because the business cycle is running hot.
“I know it’s odd to say economies are running hot when GDP is contracting in the U.S. and elsewhere, but this has been an unusual situation where we have runaway inflation and a robust labor market while other parts of the economy are slowing or even contracting. Central banks globally see inflation as the greater danger and are hiking policy rates.”
While actual rates are more volatile than neutral rates, they tend to be correlated over 10 years or more. (In this article, “neutral rates” refer to nominal long-run neutral rates.) The neutral rate can be seen as an anchor point; actual rates tend to converge to it over the long run, absent the distortions introduced by events such as the COVID-19 pandemic and the war in Ukraine.
“Those with longer memories may recall that interest rates were significantly higher in the 1970s and ’80s, unlike today, where rates have been closer to zero,” Gray said. “The neutral rate has fallen over time as demographics and savings and investment patterns have shifted across the globe. This has led to a decline in actual interest rates as well.”
Vanguard’s research—part of the Megatrend series investigating fundamental shifts in the global economic landscape—indicates that neutral rates will rise roughly 1.1 percentage point by 2030. In some ways, it’s compensation for neutral rates having fallen roughly 4 percentage points since the 1980s.
“Make no mistake, we’re not going back to the 1980s,” Gray said. “But the low rates we’ve been experiencing for the last few decades were bound to rise. We’ll see a slight reversion.”
“Central banks will likely raise rates beyond neutral in the near term,” said Roxane Spitznagel, a London-based Vanguard economist and a co-author of the paper. “Central banks almost don’t have a choice in the matter if they have any hope of reining in inflation. Bringing down inflation is paramount because low and stable inflation is good for long-run economic growth.”
As the chart below shows, Vanguard’s projections for the terminal rate through 2025 in various regions are generally higher than market consensus, but both are higher than our projected neutral rates. The notable exception is the euro area.
There, markets have started to price out additional rate hikes because of elevated recession risks. “In our view,” Spitznagel said, “the European Central Bank has to raise rates while it still can. Reduced gas flows are piling pressure on the ECB to act more forcefully now before the tightening window closes and a potential recession sets in.”