Less than three months ago, as US ten-year Treasury yields neared 5% and conventional thirty-year US mortgage rates approached 8%, many economists, strategists, financial journalists, and social media pundits were declaring the start of an era of permanently higher interest rates, with all sorts of disastrous predicted consequences for households, businesses, and government finance.
Since then, long-term interest rates have plunged three quarters of a percentage point, dampening the bearish fervor. But not entirely—just his past week former IMF Chief Economist Ken Rogoff penned a piece entitled ‘Higher Interest Rates Are Here to Stay’.
But are they? How solid is the case for higher interest rates? In our view, the answers are, not very likely and not very sturdy, respectively. It is more possible that in the coming years we will see a return to a world of low interest rates.
The Case for Higher Interest Rates
Let’s begin with the case for higher interest rates, using Rogoff’s arguments. According to Rogoff, interest rates will remain higher for the next decade due to a combination of ‘soaring debt levels, de-globalization, increased defense spending, the green transition, populist demands for income redistribution, and persistent inflation.’
That list is a plausible set of outcomes (apart from inflation, which seems more likely to return to the lower levels of recent years, for reasons we outline below). We don’t doubt, for example, that domestic and global political shifts will lead to higher spending for national security (defense), greater investment in alternative energy (‘green transition’), or to meet the populist backlash against skewed economic opportunity. Nor is there a lobby these days advocating a return to globalization.
But—and this is admittedly a relatively minor quibble—we would also note that Rogoff is engaging in deceptive double-counting. Soaring government indebtedness is partly due to increased spending on national defense, the development of alternative energy infrastructure, and to meet the demands of those less well off. His list is not, as it implicitly suggests, a set of independent drivers that can simply be summed.
The Case for Doubt
But the more important question is whether we can simply take Rogoff’s list and translate it automatically into a world of higher interest rates?
The answer is no.
To explain why not, we first need to revisit the components of the observed interest rate. Those building blocks are the real rate of interest, determined by the supply of savings and the demand for borrowing, as well as the expected rate of inflation. A ‘term premium’, to compensate lenders for the riskiness of lending over longer time periods is also a factor, albeit perhaps not completely independent of the drivers of real rates or inflation expectations.
Let’s consider each of these three constituents to weigh the arguments Rogoff puts forward to conclude that higher interest rates are on the way.
Beginning with savings, the case for higher interest rates often starts, and ends, with the observation that the US federal government is dissaving (i.e., running deficits) on a grand scale. Indeed, in fiscal year 2023 the federal government deficit reached $1.7 trillion dollars, or 6.4% of GDP. Moreover, after having shot higher during the pandemic, US household savings have fallen over the past two years.
So, dis-saving seems to fit the Rogoff thesis.
Or does it? We have omitted two other forms of savings, namely business and foreign sources. In recent years, however, US domestic business savings have surged, reaching a record $3.85 trillion (at an annual rate) in the third quarter of this year. Together with ample foreign lending, the implication is that businesses have increasingly bankrolled US government borrowing.
The deeper insight is that those who argue that rising US government deficits, alone, must push up US real rates of interests are making ‘all else equal’ assumptions. That’s wrong.
It is important to recall a simple macroeconomics accounting identity, namely that the difference between domestic savings and domestic investment, and between exports and imports, must equal the government budget balance. If ‘all else’ were equal with respect to domestic savings and investment, then the emergence of very large government budget deficits would result in a proportionate widening of the US trade deficit.
But that has not been the case. In 2015, for example, when the US federal government budget deficit was four percentage points smaller than it is today (-2.4% versus 6.4% of GDP), the US current account (trade) deficit was only 1.6% of GDP smaller than today’s level. The conclusion is that today’s large US government budget deficits have been heavily financed by rising domestic private sector savings relative to domestic private investment.
Profound conclusions emerge from that observation, providing a deeper understanding of where interest rates are headed.
The most important ought to be the worrisome development that business savings are outpacing business investment. If that remains the case, then the achievement of full employment requires persistent government dissaving, i.e., large budget deficits well into the future.
Indeed, this was the key insight associated with ‘secular stagnation’. If investment falls short of savings, full employment can only be maintained by excess government spending over taxation, or via ever-growing trade surpluses. For the US, only the former is feasible.
But why is private sector investment so subdued (relative to savings)?
Today, it might seem possible to argue that private investment has been ‘crowded out’ by huge budget deficits and high interest rates. Others might suggest that weak investment reflects corporate reticence given other ‘bad’ government policies.
Both arguments are on shaky grounds, however, for two reasons.
First, corporate savings relative to capital investment has been rising for over a decade, including during the period of super-low borrowing costs associated with ‘quantitative easing’.
Partly that is because companies have been so profitable that they generated more cash than they could spend. But investment has also been weak. Gross fixed capital formation, a measure of US business investment spending, averaged over 21% of US GDP from the late 1960s until the global financial crisis. Since then, it has struggled to regain its previous shares of GDP, including over the past decade characterized by super-low interest rates.
In short, high corporate savings and subdued corporate investment preceded the recent episode of big budget deficits and high interest rates. Crowding out is not to blame.
Similarly, it is implausible to argue that other ‘bad policy’ accounts for weak investment. How bad can things be when average levels of profitability have not been higher at any time since the second world war? Also, recall, that corporate income taxes were slashed under President Trump. And, we are told, re-shoring foreign factories is the new standard in a post-globalization world. Yet business investment continues to languish.
Finally, it is worth considering the role of foreign savings when assessing where real interest rates are headed.
If the rest of the world were enjoying an investment boom or witnessing a large drawdown in their savings, then those factors combined with large US federal government budget deficits would conspire to push up the global real rate of interest.
But that’s not happening. The world’s other two major economic regions, the Eurozone and China, are struggling, burdened by a massive energy transition costs and huge overhangs of excess investment, respectively. They are not booming, nor heavily investing. And both are running current account surpluses, providing excess savings to borrowers, including the US government.
In sum, the case for higher real interest rates based on large US government budget deficits, alone, is weak. It does not consider savings and investment decisions elsewhere. And, on closer inspection, most of those outcomes look more like the era of ‘secular stagnation’ and its low interest rates, than representative of a decade ahead of high interest rates.
What About Inflation?
What about inflation? Indeed, what about it? Well, it is now crashing back down toward levels desired by central bankers. Notably, those declines in inflation have occurred without much slack appearing in the economy or labor markets, which is a clear indication that pandemic-era inflation was not driven by sustained conditions of excess demand, but rather by temporary restraints on supply, most of which have vanished.
Of course, inflation can return. But that does not make its recurrence either inevitable or likely.
Perhaps the chief lesson economists have (re)-learned during the recent inflation scare is that persistent inflation, as envisaged by Rogoff, requires some combination of persistent supply shocks, persistent excess demand, or higher inflation expectations (leading to wage-price spirals).
Yet none of those drivers of ‘persistent’ inflation are present today. Demand is softening globally, including more recently in the US. Labor shortages are receding. Vivid images of freighters queuing at ports have long-since disappeared from our screens. And expectations of future inflation, as captured by surveys or in asset prices, are back where they were during the low inflation era that preceded the pandemic.
It must just be me, but I fail to see the preconditions for persistent inflation.
Which leaves us with term premiums—the additional compensation lenders require for the uncertainty of lending for longer periods of time.
Term premiums, and hence observed interest rates, ought to be higher when the future is less certain, as many would argue is the case today. But if, instead, the US and world economies are slipping back to a world of secular stagnation, characterized by weak growth, muted investment spending, and low inflation, the result is apt to be one of low and stable interest rates. If so, term premiums aren’t going to rise.
The notion that interest rates must remain elevated because of high levels of government borrowing is a popular, but misguided, one. For the counterfactual, look no further than a quarter century of Japan’s experience. Government borrowing, alone, does not determine the real rate of interest. Private sector decisions are decisive.
Equally, the idea that inflation will be persistently high is popular. But it, too, is not well supported by logic, nor the collective wisdom of crowds.
Absent recurring aggregate supply and demand shocks, or a global private sector investment boom, the most plausible case is that interest rates are now in the process of reversing a temporary blip and will settle down closer to the norms of recent decades.
Lower, not higher, interest rates are here to stay.