It is often argued that once our economy passes this burst of inflation, interest rates will return to their pre-pandemic levels and will probably go lower in the future. Central banks, international organizations and almost all economic institutions seem to operate under this assumption. But what if it’s wrong?
The thinking is that there is a ‘natural interest rate’ that governs rates set by the Fed and the market. It reflects the productivity of the economy and the supply and demand for bonds. The theory among the world’s major financial institutions is that the US natural rate is on a downward trend and a large part of the reason is the aging population.
This is not just an academic argument. The implication is that the US can continue to spend because rates will eventually go back to the near-zero rates of the last decade and governments will never really have to think about their debt, because it won’t cost them much to borrow. .
Olivier Blanchard, one of the world’s most influential macroeconomists, recently argued this. The private sector is also hoping for a rate cut once the Fed gets inflation under control, which will mean free money and cheap mortgages will soon be back.
But what if this is not true? What if the falling rates of the past few decades were more of an anomaly and an aging population would mean higher, not lower, rates?
Research by Harvard professor Ken Rogoff questions whether rates will continue to fall as the population ages. Real interest rates have been trending downwards near zero, especially since the financial crisis. But we cannot expect that trend to continue. He and his co-authors looked at 10-year rates over the past 700 years and found that they declined modestly and steadily as the world became safer and financial markets developed.
But they also found periods of very high or exceptionally low rates that were deviations from the long-term trend. These deviations can last for many years, and he argues that the last 15 years was a period that was not part of a sustainable path. They also speculate that, historically, it is younger populations, not older ones, that result in low rates. The aging population was just a fad, with falling rates over the past few decades.
The theory that an aging population means lower interest rates gained strength over the last 30 years as rates fell and boomers got older. The logic is that people save more as they age, and with better life expectancy, they need to finance a longer retirement. There is also the idea that with fewer and older people working, the economy will be less productive, and that means the return on capital will also fall.
These sound logical, but as Rogoff argues, they may not last long.
First, there is no certainty about future productivity in an environment of constant technological change. Economists recognize that an older population is less productive, but with the emergence of so many new technologies, there is reason to think that productivity will increase and interest rates will rise with it.
Second, people in many developed countries are not saving enough for retirement. And over the next 10 to 15 years, they will become more dependent on the state to pay for their consumption and medical care. Governments are not saving in anticipation of this event. They are doing the opposite by increasing spending.
Unless governments consider cutting benefits, which seems highly unlikely, they will need to borrow more to pay for their growing populations and flood the market with more bonds. This will increase the rates. Even the International Monetary Fund (a supporter of falling rate theory) acknowledges that any increased savings by households seeking to retire could be swamped by more government borrowing. This makes it very difficult to predict the future of interest rates.
We should also be concerned because interest rates are largely a function of market risk, not just some abstract natural rate. [that balances an economy’s savings and investments], There is a risk that countries will default, or that bonds will be illiquid – although these are not major concerns in developed countries. But there is a very real risk that future inflation could be higher and more volatile. Rates have come down over the past few decades for a variety of reasons, but one major period was a notable period of very low and stable inflation that reduced the risk premium on bonds to zero. An aging population could mean higher inflation, and would also mean higher rates.
And yet the theory is that an aging population will assure lower interest rates in the future. This is one of the main reasons why some policymakers and investors expect rates to return to their pre-pandemic levels. But if we get that backwards, rates could go higher, and everything we thought we knew about bonds would be wrong.
Allison Schrager is a Bloomberg Opinion columnist who covers economics and author of ‘An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk.’
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