Why is the neutral rate of interest rising and should we care?

Why is the neutral rate of interest rising and should we care?

Tim Richardson CFA, Investment Specialist

The neutral rate of interest appears to be rising as households spend more and save less, while business investment levels rise. This will impact borrowing costs, affecting industries and companies in different ways.

Money often costs too much.”
– Ralph Waldo Emerson (1803-1882), American writer

What is the neutral rate of interest?

The neutral rate of interest is the rate at which the supply of savings and the demand for investment are in balance, bringing stable inflation and economic growth.

The neutral rate cannot be observed directly but is inferred by analysing data. If inflation is rising and unemployment is falling, then chances are the prevailing interest rate may well be below the neutral rate – and vice-versa.

Interest rates were lowered to levels well below neutral across developed markets when economic activity slowed at the start of the COVID-19 pandemic. This had the desired effect of encouraging households to maintain spending. When this began to push inflation higher in late 2021, major central banks (eventually) increased rates to levels back above the neutral level as spending proved more resilient than had been expected. This has now slowed economic activity as households cut back on discretionary spending and businesses delay their investment plans.

The US Federal Reserve regularly publishes its forecast of long-term interest rates, which is seen as a proxy for the neutral rate. Since mid-2019 the nominal neutral rate has been 2.50%, i.e. a real rate of 0.5% plus its 2.0% inflation target. In Australia, the neutral rate may be a little higher. However, there can be a wide range of opinions on neutral rate levels.

Does the neutral rate change?

The neutral rate of interest is not fixed and will vary over time as the economic environment evolves. Over the last ten years, it drifted down from 4.0% to its current 2.5% level, having fallen over previous decades.

This change in the neutral rate has been driven by the following factors:

  • Weaker productivity growth impacting potential economic output, reducing demand for investment.
  • Lower risk appetite following the GFC reduced investment activity and increased savings.
  • The savings glut in Asia, especially China, meant more cash was chasing the available investment opportunities.
  • Rising inequality shifted wealth to richer cohorts, who save more and spend less.
  • Fiscal consolidation – especially in Europe – is reducing the demand for debt.
  • Increasingly regular financial stress increased demand for high quality bonds, especially US Treasuries.

Falling demand for investment and rising supply of savings reduced the neutral rate of interest.

Why is it now increasing?

Some economists believe the neutral rate of interest is now rising again and the trend could prove to be long lasting. Factors pushing up the neutral rate include:

  • The transition to green energy and the boost to productivity growth from artificial intelligence (AI) innovation will increase demand for investment.
  • Business investment, which is increasingly dominated by software rather than buildings, now depreciates faster, making it less sensitive to interest rates, which should boost investment.
  • Lower inflation-adjusted asset values, especially housing, may increase investment and reduce saving.
  • An ageing population, increasing inequality and rising geo-political insecurity are increasing demands on public spending beyond governments’ ability to raise additional taxation. This implies rising fiscal deficits and public debt levels, which will put upward pressure on the neutral rate of interest.
  • A rising dependency ratio as people spend more time in education and live longer in retirement will reduce the supply of savings in the economy.

Higher demand for investment and a lower supply of savings now appear to be driving up the neutral rate of interest. Some suggest it has now risen to around 3.50% in the US, with comparable increases in other developed economies.

A higher neutral rate means that interest rates will on average be higher in the future than they were over the last decade. This provides central banks with more scope to cut interest rates when the economy slows and less need for negative rates or quantitative easing.

What does this mean for investors?

This implies that longer-term bond yields and financing costs to businesses will be higher over the course of the economic cycle. This will impact corporate earnings and market valuation levels.

Such an environment may favour companies that demonstrate:

  • Strong balance sheets with limited borrowings, that support debt refinancing on favourable terms in any credit environment
  • Positive cash flows that can support new investment opportunities
  • Sustainable earnings which can grow at higher rates over the long-term

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