What is the "right" interest rate anyway?

The ten-year Treasury yield rose toward 4.35 per cent, its highest since 2007, and bond investors are having to ask an awkward question. What if the neutral real rate of interest, the elusive r-star that neither stokes nor smothers inflation, has moved permanently higher? For a decade after the financial crisis, central bankers assumed secular stagnation had pinned it at zero.

The decade of cheap money

The low-rate consensus had solid foundations. Lawrence Summers revived the phrase secular stagnation in 2013 to describe an economy in which desired saving persistently exceeded desired investment, so that only very low interest rates could balance the two. Ageing populations in rich countries were saving for retirement, China and other surplus economies were piling up reserves, and business investment was weak after the crisis. Estimates of the neutral real rate built on this view fell to around zero, and central banks set policy accordingly.

The Federal Reserve's own projections still reflect that thinking. The median long-run policy rate in its June forecasts was 2.5 per cent, which, with inflation at the two per cent target, implies a neutral real rate of only half a percentage point. Model-based estimates in the tradition of Holston, Laubach and Williams sit around one per cent. By those yardsticks today's policy rate is extremely tight.

Capital is in demand

That assumption is breaking down. Governments are running chronic deficits and spending more on defence, while the energy transition and the reshoring of supply chains need vast sums. Together they seem to have outrun the world's supply of savings. If the real neutral rate has risen from zero to two per cent, policy rates of 5.5 per cent are only moderately restrictive.

The evidence is circumstantial but accumulating. The Fed has raised its policy rate to a range of 5.25 to 5.5 per cent, yet unemployment remains near half-century lows and growth has repeatedly beaten forecasts. Ten-year inflation-protected Treasuries now pay real yields close to two per cent, which suggests investors expect real rates to stay well above zero for years. An economy that shrugs off the fastest tightening in four decades is either slow to respond or less restrained than the models claim.

How the balance shifted

The neutral rate is the price that clears the market for savings and investment. Several forces are now pushing on the investment side at once. America's deficit is running near six per cent of GDP in a year of full employment, and the Inflation Reduction Act and CHIPS Act offer large subsidies for private spending on factories, batteries and grid equipment. Europe is raising defence budgets after Russia's invasion of Ukraine. Companies are building duplicate supply chains to reduce reliance on China, which raises the stock of capital needed to produce the same output.

On the savings side, the shift is subtler. China's surplus savings are still large, but less of them is flowing into Treasuries, and the Fed and other central banks are shrinking their bond holdings rather than adding to them. The price-insensitive buyers who absorbed government debt in the 2010s have become sellers, leaving private investors to set the price.

A higher rate is not new

History suggests a neutral rate near zero was the anomaly. When the Treasury first sold inflation-protected bonds in 1997, they paid real yields above three per cent, during a period of strong productivity growth and budget surpluses. Real rates were positive through most of the 1980s and 1990s. The long decline that followed was driven partly by the forces Summers described and partly by the global savings glut that Ben Bernanke highlighted in 2005. If those forces are fading, rates could revert towards an older norm.

Winners and losers

A higher neutral rate reprices every long-lived asset. Savers, insurers and pension funds with long-dated liabilities gain, since they can earn positive real returns without taking much risk. Borrowers who built businesses on cheap refinancing lose, particularly commercial property owners, leveraged buyout firms and companies that have survived only because debt was nearly free. Growth stocks whose value depends on distant profits are hurt most, because a higher discount rate shrinks the present value of those profits.

Governments are among the biggest losers. A higher neutral rate means the interest bill on public debt will rise as old low-coupon bonds mature and are refinanced. For a country running large primary deficits, that adds to a debt dynamic already heading in the wrong direction.

The case for patience

The strongest counterargument is that the forces behind secular stagnation have not gone away. Populations in America, Europe, Japan and China are still ageing, and older societies tend to save more and invest less. Productivity growth has been weak for more than a decade. Some of the economy's resilience may reflect pandemic savings and fiscal support that will fade, in which case the lagged effects of tighter money could still produce a sharp slowdown, and rates would fall back.

That argument deserves weight. A single cycle of strong growth under high rates is not proof that the neutral rate has shifted, and structural estimates move slowly for good reason. But the burden of proof has changed. For a decade, the assumption of a low neutral rate was treated as settled; it now looks like an extrapolation from a period of unusual conditions that are unwinding.

What to watch

Jerome Powell speaks at the Jackson Hole symposium later this week, and any hint that the Fed doubts its own neutral-rate estimates would be news. The next set of projections, due at the September meeting, will show whether officials have raised their long-run rate. Beyond the Fed, the signals are real yields on inflation-protected bonds, productivity data, and whether business investment holds up at current borrowing costs.

If the neutral rate has moved up for good, bond investors waiting for the low yields of the 2010s to return are positioned for a world that has gone, and they will probably wait a long time. The clearest loser over the next few years will be anyone who borrowed short on the assumption that refinancing would be cheap, from commercial landlords to heavily indebted governments.