The new normal for interest rates is higher

The Federal Reserve’s Summary of Economic Projections has started to back away from the idea of secular stagnation. For years the committee put its longer-run median policy rate at 2.5 per cent, which implied a real neutral rate (r*) of only 0.5 per cent. Fiscal reality is now pulling that anchor loose.

How the anchor sank

The long-run estimate did not start that low. When the Fed first published its rate projections in 2012, officials put the longer-run policy rate above 4 per cent. Each year of weak growth and sub-target inflation after the financial crisis dragged the median lower, until it settled at 2.5 per cent in 2019. The intellectual backing came from Larry Summers's revival of secular stagnation in 2013 and, before that, from Ben Bernanke's global saving glut: too much saving chasing too few investment projects, holding down the rate at which the two balance.

The pandemic and its aftermath broke that pattern. The Fed raised its policy rate by more than five percentage points in about 16 months, and the economy kept growing with unemployment below 4 per cent. Real yields on ten-year inflation-protected Treasuries, negative in 2021, have climbed well above 1 per cent. A neutral rate as low as the committee assumes would have made that tightening far more painful than it has proved.

Deficits push up r*

Demographics play a part. So do federal deficits running into the trillions of dollars and the heavy capital spending needed for artificial intelligence and decarbonization. Together they are raising the cost at which capital clears, probably for good. A neutral rate of 2.5 per cent looks dated in an economy with persistent fiscal expansion. The Fed will probably have to keep nudging its long-run rate assumption higher.

The mechanism, step by step

The neutral rate is the price that balances saving against investment when the economy is at full employment and inflation is stable. Deficits absorb saving: every dollar the Treasury borrows is a dollar that must be drawn from households, firms or foreigners, and it must be priced to attract them. The federal deficit came to about $1.7 trillion in fiscal 2023, with no sign of closing, and the Congressional Budget Office projects debt rising as a share of GDP over the coming decade. On the other side, investment demand is climbing, pushed by the Inflation Reduction Act's clean-energy subsidies, the CHIPS Act's grants for chip plants and the data centres that AI requires.

Ageing adds pressure from the saving side. Charles Goodhart and Manoj Pradhan have argued that as baby-boomers retire, they run down savings rather than add to them, while a scarcer supply of workers pushes firms to invest in machines. More demand for capital and less supply of it both push the clearing rate up.

What the 1980s taught

There is a precedent for deficits lifting real rates. In the mid-1980s, large federal deficits under Ronald Reagan coincided with a tight Fed under Paul Volcker, and real interest rates reached the highest levels of the post-war era, pulling capital into America and driving the dollar up so far that the big economies agreed at the Plaza in 1985 to bring it down. In the 1990s, when deficits shrank and eventually turned into surpluses, long-term rates fell. The link between fiscal policy and the price of money is not new; it was simply masked for a decade by low inflation and central-bank bond buying.

Where the committee stands

The median has not yet moved, but the distribution has. In recent projections a growing minority of officials have put their longer-run estimate above 2.5 per cent, while model-based estimates such as the one maintained by the New York Fed, built on the work of Thomas Laubach and John Williams, have stayed low. The gap between what officials observe, an economy that has shrugged off rates above 5 per cent, and what the models say is itself a sign that the old consensus is under strain. Jerome Powell has said the committee does not know with any precision where the neutral rate lies, which leaves room for the estimate to drift.

Winners, losers and the case against

Savers and holders of cash are the obvious winners, earning a real return after a decade of near-zero rates. Borrowers who relied on cheap refinancing lose most: highly leveraged companies, commercial property owners, private-equity deals priced for low rates and governments with heavy debts. Property and long-duration equities are worth less when future cash flows are discounted at a higher rate.

The strongest counterargument is that the forces behind low rates have not gone away. Productivity growth over the past decade has been modest, many rich countries and China still generate large surpluses of saving, and demand for safe assets tends to jump in any crisis. Ageing societies may also save more for longer lives, and AI could turn out to raise output without needing vast new capital spending. The Fed's estimate is also only a median of officials' guesses, and it has been wrong in both directions before.

That argument deserves weight, but it has to explain why the economy has absorbed rates above 5 per cent without breaking. The indicators to watch are the longer-run dots in the Fed's next projections later this month, real yields on inflation-protected Treasuries, and the term premium on long bonds. A rise in the median above 2.5 per cent would confirm the shift; a steady median alongside high real yields would suggest the market is ahead of the Fed.

The Fed's rising neutral-rate estimate suggests cheap money was the exception. Borrowers still waiting for the rates of the last decade to return are likely to wait a long time, and the committee's longer-run median is likely to edge above 2.5 per cent within the next year.