But our scenarios and paradigms work also take seriously the forces that could be pushing up on r*, highlighting the risks of a much shallower easing cycle.

Why r* matters

The real equilibrium interest rate, sometimes called the natural rate, the neutral rate, or r*, is the theoretical interest rate that would keep economic growth at potential and inflation at target.

Put another way, r* defines the level of interest rates at which monetary policy switches between stimulative to restrictive.

While this may seem like an esoteric concept, we keep coming back to it because r* is crucial to understanding the impact of monetary policy on the economy, and where interest rates may be heading in the long run.

But r* is an unobservable concept, influenced by a wide range of factors operating over differing time horizons, and estimated with large error bands. The path of policy rates will be determined both by how r* behaves and also by central banks’ shifting interpretation of how restrictive their stances are in real-time.

What determines r* over the long term?

Over the long term, r* is pinned down by the balance of desired saving and desired investment in the economy.

A wide variety of factors influence this, including potential growth and productivity, demographics, technology and the relative price of capital, income and wealth inequality, fiscal policy, time preferences, capital market integration, and the global demand for safe assets.

For example, stronger growth raises the rate of return on investments – spurring demand for funds to invest – while expectations of stronger future income growth can support household consumption by reducing the need to save. Desired investment increases and desired saving falls, causing equilibrium interest rates to rise.

The secular decline in market interest rates since at least the 1980s up until the pandemic, as well as the difficulty central banks previously had in hitting their inflation targets, suggest that these long-run drivers were coalescing to keep r* at historically low levels.

Where has r* gone since the height of the pandemic?

Pressures from the pandemic abating – supply chains and labor supply recovering, for example – combined with higher central bank policy rates are reasons why one might expect a moderation in short-term r*.

Estimating r* is a non-trivial exercise and the uncertainty bands are very large. But our model-based estimates of r* for both the US and Eurozone have indeed returned close to their pre-pandemic levels (Chart 1).

This is consistent with considerable progress in reducing inflationary pressures, even if ‘last mile’ concerns have emerged (Chart 2).

The resilience of the US economy and a still challenging inflation backdrop across key dimensions, such as services inflation and wages, could imply that in effect short-run r* remains relatively high and correspondingly monetary policy is only modestly restrictive.

An effectively still-elevated short-run r* in the US could be motivated by three factors:

1. Strong private sector balance sheets have likely muted the pass-through of tight monetary policy settings. Corporates were able to lock in low rates when borrowing after the pandemic, meaning their margins have been less affected by rising interest costs. Households meanwhile have been able to draw upon excess savings to finance strong consumption growth.
2. Loose fiscal policy has provided a not insignificant support to growth. The Federal budget deficit widened by nearly 4 percentage points of GDP last year.
3. The US economy enjoyed several favorable supply shocks in 2023, which have supported growth and helped inflation to fall. Labor productivity increased by the most seen in almost 20 years and strong immigration has provided a significant boost to the labor force.

Where does r* go from here?

The factors that could effectively be propping up short-run r* seem likely to moderate for 2024, suggesting that policy should exert an increasing drag on activity and take heat out of the inflation prints.

It is however possible that we are too optimistic about the policy-growth-inflation nexus.

US activity growth continues to be robust: the labor market added an average of 276,000 jobs per month so far in 2024 and real consumer spending is strong.

CPI inflation once again came in hot in March, with both the headline and core rates increasing by 0.4% month over month. As the year progresses, it is becoming increasingly hard to attribute this strength to residual seasonality and other quirks.

The factors bolstering the US economy may persist, challenging our understanding of the monetary transmission mechanism. If inflation proves to be more persistent, it will be hard for the Fed to take policy rates back towards neutral.

We ran several scenarios through our r* model to test the impact different constellations of growth and inflation might have on equilibrium rate estimates. These typically pushed forecasts for r* higher by between 50–100 bps, with a ‘no landing’ scenario - in which growth and inflation continue to run very hot - driving the largest increase (Chart 3).

These profiles may be more consistent with current market pricing, suggesting that r* may settle somewhere in between pre-pandemic norms and the peaks hit in the pandemic. But they are also a reminder of the extraordinary nature of this shock and the potential that markets could be underappreciating the eventual cutting cycle required to bring policy settings to neutral over the medium to long term. All scenarios at least still imply that the Fed will eventually be able to guide rates lower.

Could secular trends push up long-run r*?

Modeling how slow-moving secular trends – such as demographics - may impact r* comes with a large amount of uncertainty. Our research suggests that it is difficult to motivate an abrupt move upwards in long-term r* as a result of demographics.

Demographic trends are becoming more adverse as populations age, but the impact on real equilibrium rates from higher dependency ratios and faster aging continues to be more than offset in many countries by downward pressure from slower growth in working-age populations. Put simply, the net balance between how demographics impact potential growth vs. savings-investment balances does not yet point to r* trending higher.

Moreover, while much of the financial market debate is laser-focused on the US, r* should be considered as globally determined and this reduces upside risk.

Financial links between emerging markets (EMs) and DMs are certainly weaker than within DMs, but this implies a less contemporaneous influence rather than no effect. Indeed, while official reserve accumulation is not the focal point it was when Chair Bernanke opined on the ‘global savings glut’, trends in Net International Investment Positions (NIIPs) imply that EM savings continue to exert pressure on DMs (Chart 4).

EM growth is also typically slowing and is likely to reinforce the low equilibrium rates of the major economic blocs (US, Eurozone, and China), rather than amplify channels of upward pressure. China will likely flip from relative support of global r* to drag towards the end of this decade, as falling potential growth more than offsets any upward pressure from its worsening demographic profile (Chart 5).

Could structural change come through more abruptly?

Artificial Intelligence (AI) certainly has the potential to generate a profound step-change across companies and the economy. Estimates for the impact on potential growth (Y*) - and therefore also r* - tend to be modest over the near term, even if they become more significant in the long run.

Of course, while this would imply little near-term upward pressure on r*, a larger impact could occur more quickly via companies' current AI-related investment spend. If combined with higher green investment and defense spending by governments, the cumulative private and public sector shift in desired investment could shift r* up suddenly.

Again, scenario modeling helps to gauge the potential impact. In our modeling, we first increased potential growth for DMs and EMs by 0.25 ppts and 0.5 ppts, respectively, to reflect productivity gains from AI. Secondly, and relatedly, we increase the capital stock to GDP ratios to reflect higher investment rates as governments and firms take more aggressive steps to combat the climate crisis and firms embed AI.

The model pushes global r* up by almost 50 bps, keeping it closer to the pre-pandemic average (Chart 6).

But it still implies that headwinds from weaker labor force growth will be difficult to counter. Moreover, AI could potentially push up on both productivity and inequality, implying the r* boost could include an offsetting component.

Important information

Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed, and actual events or results may differ materially.

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