Academic journal article Economic Perspectives

Understanding Global Trends in Long-Run Real Interest Rates

Academic journal article Economic Perspectives

Understanding Global Trends in Long-Run Real Interest Rates

Article excerpt

Introduction and summary

Real, or inflation-adjusted, interest rates may well be the most important prices for any nation's economy. They govern intertemporal purchasing decisions facing households, firms, and all levels of government. That is, virtually all interactions in the marketplace that entail making a choice between spending now and spending later necessarily involve real interest rates, which specify the real cost of borrowing to make a purchase or, on the flip side, the real gain from saving.

As we show in a recent paper (Yi and Zhang, 2016), there is no discernible trend in long-run real interest rates (1) for the 20 largest economies in the world that spans the entirety of the past 60 years. However, over three subperiods, distinct trends can be observed. (2) We see a general decline in global real interest rates from the early 1960s through the mid-1970s, then an upward trend in these rates until the late 1980s, and finally, another downward trend through the present day. Moreover, we observe that long-run averages of real interest rates across countries have converged over the past quarter of a century--a pattern consistent with an increasingly financially integrated world.

In this article, we use a simple theoretical framework to derive the fundamental economic forces behind movements in long-run real interest rates. Our framework implies an arbitrage relationship that links the risk-free real interest rate to the marginal product of capital, or MPK (the additional output from an extra unit of physical capital, such as machinery); the depreciation rate of capital; and the risk premium (which captures the riskiness of a capital investment). Specifically, the lower the MPK, the higher the depreciation rate of capital, and the greater the risk premium, all else being equal, the lower the real interest rate is. In addition, we use our framework to derive the forces underlying MPK itself--such as total factor productivity (TFP) (3) and the capital-to-labor ratio. A decrease in TFP and an increase in the capital-to-labor ratio will tend to decrease MPK (and therefore real interest rates).

We examine the long-run averages of real interest rates and these related variables for 20 countries during the past 60 years or so. We find that the declining trend in long-run MPKs is consistent with the declining trend in long-run real interest rates in the 1960s and early 1970s. However, over the past three to four decades, the relationship between the two variables appears to have weakened. This implies that movements in long-run risk premiums have played a growing role in explaining the trend in long-run real interest rates. In particular, the estimates of the long-run interest rates and MPKs suggest that long-run risk premiums have increased as long-run real interest rates have decreased over the past two decades.

It is difficult to predict what will happen to long-run averages of real interest rates in the United States and abroad. However, we present evidence that growth in U.S. total factor productivity and growth in the global working-age population (factors affecting MPK) are projected to be lower than they were before. These shifting trends are expected to continue to put downward pressures on long-run real interest rates.

Understanding the fundamentals driving long-run real interest rates matters for the household, business, and government sectors of an economy and especially for monetary and fiscal policymakers. For monetary policymakers (central bankers), the long-run real interest rate may provide a useful reference point to help calibrate the future path of the monetary policy interest rate so that the central bank provides the appropriate level of accommodation. For example, versions of the Taylor rule (4) (a well-known economic equation for setting the monetary policy rate) have an intercept term that can be interpreted as the long-run real interest rate. …

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