Economics and markets
August 26, 2022
In the near term, to curb runaway inflation, central banks are likely to further raise the short-term interest rates they control. Over the long run, market-driven intermediate- and long-term rates will fluctuate as the economy heats and cools, but on average all interest rates will be higher because of global shifts in demographics, risk aversion, and the global savings glut.
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.”
Notes: Vanguard’s long-run nominal neutral rate forecast assumes 1.8% inflation for the euro area and 2% inflation for the remaining countries. Market terminal rate is the maximum overnight indexed swap implied rate between 2022 and 2025.
Source: Vanguard calculations, based on Bloomberg data as of August 9, 2022.
While inflation is clearly a major reason why both the terminal and neutral rates are rising, what other factors are driving up the underlying neutral rate?
“Vanguard has a proprietary model that looks at six factors in two broad categories—investment and savings—and where those two lines intersect is the neutral rate,” Gray said. “The factors shift the savings and investment lines up and down, changing the intersection of the two lines.”
Three of the six factors will make most of the difference over the coming decade.
“Of the three, demographics is the most certain,” Gray said. “The proportion of younger workers will increase in most countries. And they typically have a lower savings rate, which shifts that line, raising the intersection, or neutral rate, higher.”
We also expect risk aversion to normalize to lower levels, pushing the investment line and the neutral rate higher.
But the factor making the most impact is the global savings glut—or, more accurately, less of a glut in a single country.
“China is the behemoth that overwhelms the scale,” Gray said. “It has a population of 1.4 billion and had an unprecedented economic boom over decades. With its pace of growth slowing down, it has an outsized impact on reducing the savings glut that’s chasing limited investments, pushing up the neutral rate.”
Notes: The chart is a theoretical diagram for illustration purposes only. The intersection of the savings and investment lines represents the neutral rate in the long run, absent global and country-specific distortions. As one or both lines shift left or right, the intersection changes as well.
Source: Adapted from Gray, Alexis, Roxane Spitznagel, and Adam J. Schickling, 2022. Estimating Neutral Rates: Why the Era of Ultra-Low Rates May Be Coming to an End. Valley Forge, Pa.: The Vanguard Group.
In the United States, we expect the neutral rate to rise about 90 basis points to 2.8% by 2030.
“Compared with the U.S., demographic factors have played a larger role in driving down neutral rates over the last decades in the euro area,” Spitznagel said. “We therefore expect euro area neutral rates to increase to a larger extent than in the U.S., but to remain below the U.S. level. Of course, the extent and level of the increase will depend on the specific conditions in each euro area country.”
In the U.K., our estimates show that neutral rates are already much higher than in the euro area. And we expect an increase to above 3% by 2030.
“In Australia, we expect the neutral rate to rise by about 100 basis points, taking it to around 4% by 2022,” Gray said. “We expect an increase of similar magnitude in Japan, taking the nominal neutral rate from around 1.2% to 2.2%.”
The chart below shows our projected long-run nominal neutral rates through 2030 for select countries.
Notes: The nominal neutral rates assume a steady-state inflation rate of 1% for Japan and Switzerland, 1.8% for the euro area, and 2% for all other countries.
Source: Gray, Spitznagel, and Schickling (2022).