What is the most important price in the world economy? That of an oil barrel? A microchip? Or maybe a Big Mac? More important than any other is the price of money. For more than three decades, it was falling. Now it’s going up. Forces that were driving the price of money lower have reversed course.
An example is the yield on 10-year US Treasury bonds, which has jumped to 5% in recent weeks, raising the cost of mortgages and corporate loans. At first it seemed like a passing phenomenon, but when what seemed like a small upheaval turned into a disaster in the bond market, an alternative explanation emerged: investors are now realizing that something fundamental has changed. Money will remain expensive for a long time – and not just because the Federal Reserve is taking longer than expected to fight inflation.
How is the value of money defined?
Most will say from the central banks. It is true that the Federal Reserve is responsible for setting interest rates. Inherently, however, the price of money, like anything else, reflects the balance of supply and demand. When the supply of saving expands because, for example, workers earn more than their wages, then costs fall. If the demand for investment increases rapidly – because the government pours money into road upgrades or because companies take off through the use of factory robots – then costs rise.
For economic theorists, the price of money that balances saving and investment while keeping inflation constant is called the “natural rate of interest” or r-star. To understand why this concept is central to policymaking, imagine what would happen if the Fed set borrowing costs well below the natural rate. With money too cheap, there would be too much investment and not enough saving, the economy would overheat, sending inflation spiraling upwards. Conversely, if the Fed were to set the cost of borrowing above the natural rate, there would be too much saving and not enough investment, and the economy would cool, pushing unemployment up.
This balance point is notoriously difficult to determine. “The natural rate of interest is an abstraction, like credit, from his works,” wrote the American economist John Henry Williams in 1931. According to Williams, “if bank policy succeeds in stabilizing prices, the bank rate will logically is aligned with the natural rate of interest, but if prices are not fixed, the opposite is true.”
Nearly a century later, the r-star retains much of its ambiguity, which is why Fed Chairman Jerome Powell has repeatedly expressed skepticism about its usefulness as a guide for monetary policy.
The conflicting opinions and the right indicator
But there are opinions that we have reached a turning point. Former US Treasury Secretary Lawrence Summers and Kenneth Rogoff, once chief economist at the International Monetary Fund, both argue that the era of cheap money is over, citing factors such as increased government borrowing to finance increased military spending and the shift to a greener economy.
On the other hand, there are opposing views as well: “Today’s inflation won’t last, but I think low interest rates will return,” Olivier Blanchard, another former IMF chief economist, wrote in a blog post for the Peterson Institute for International Economics. These views argue that the forces that were driving down the natural rate before the pandemic – such as demographics and sluggish productivity growth – will re-emerge once inflation has abated.
The most important indicator in these cases is the yield on the 10-year US federal government bond. The yield on 10-year US Treasuries has fallen from 5% in 1980 to just under 2% over the past decade.
The Forces that drive the price of money lower-higher
One of the major reasons for the decline in the natural rate was weaker economic growth. In the 1960s and 1970s, gross domestic product expanded by an average of nearly 4% per year thanks to a combination of a growing labor force and – at the beginning of that period – rapid productivity growth. By the 2000s, however, these forces began to fade. In the wake of the global financial crisis of 2007-08, average annual GDP growth fell to around 2%. Investments for the future became less attractive, dragging the natural rate lower.
Changing demographics contributed in another way. From the 1980s onward, as America’s baby boomers began saving more for retirement, the supply of savings increased, putting more downward pressure on the natural rate.
There were other factors that affected the price of money. China has begun to recycle some of its growing trade surpluses into US bonds. And in the US, income inequality worsened, which resulted in an expansion in the supply of savings, as high earners tended to save more of their income.
On the investment side, computers became cheaper and more powerful, so companies no longer needed to spend as much to upgrade their technology infrastructure, also driving the natural rate lower.
For the US economy, this fall in the price of money had profound consequences. The depressed cost of borrowing allowed households to take on larger mortgages. And in the early 2000s, many bit off more than they could chew, which helped set the stage for the global financial crisis.
Cheaper money also meant that even as the US federal debt nearly tripled, from just over 30% of GDP in 2000 to more than 90% today, the cost of servicing that debt remained low, allowing the government to keep spending without limits. For the Fed, a lower natural rate meant less room to cut rates during a recession, leading to many concerns about reduced monetary policy firepower.
Reverse course
All this is changing. Some of the forces that drove the price of money lower have now reversed course. And other factors come into play.
Baby boomers are leaving the workforce and spending their nest eggs, which reduces savings. Meanwhile, China’s appetite for US bonds has been dampened by tensions between Washington and Beijing and by the partial restructuring of China’s economy.
US federal debt rose as the global financial crisis hit the economy and again when the coronavirus pandemic hit. Government spending on stimulus measures has declined, but deficits remain large and competition for investment capital has intensified. That’s partly due to incentives in federal laws that have sparked a boom in electric vehicle and semiconductor plant construction. Rising debt puts upward pressure on long-term borrowing costs.
How much higher will the “natural rate of interest” or r-star move?
Yields on the 10-year US federal government bond could settle somewhere between 4.5% and 5%. Risks point to even higher borrowing costs than the baseline scenario suggests.
In this, governments are finally taking action to put lending on a sustainable path. But as Democrats and Republicans struggle to find common ground on how to put America’s fiscal house in order, there is a clear danger that deficits will remain large for the foreseeable future. Action to tackle global warming has so far been modest, but if the world is to get serious about it, massive investment will be required. It is estimated that the energy infrastructure needed to support a zero-emissions economy will cost around $28-32 trillion globally, an amount equal to around 30% of global GDP last year. And rapid advances in artificial intelligence and other cutting-edge technologies could boost productivity, putting the US on a faster growth trajectory.
The combined impact of persistently high levels of government borrowing, greater spending to combat climate change and faster growth would push the “natural rate of interest” or r-star up to 4%, translating to a nominal US 10-year Treasury yield in the range of 6-6.5%.
The consequences
Even under the least extreme scenario, the transition from a falling to a rising natural interest rate would have profound consequences for the US economy and the global financial system. Subprime mortgages have been a major contributor to the nearly relentless rise in US home prices since the 1980s, creating an affordability crisis.
There is a similar story in the stock markets. Since the early 1980s, the S&P 500 has been rising, in part because of lower interest rates. With borrowing costs rising, this impetus for ever-increasing house and stock valuations will be removed.
The shift to higher interest rates can trigger an episode of creative destruction, sweeping away legions of corporate zombies. The number of unprofitable companies has increased in recent decades, reaching almost 50% of all listed companies worldwide in 2022. In an ideal world, an increase in bankruptcies could result in reallocation of capital and labor to more efficient purposes.
The big loser
Perhaps the biggest loser in this new high interest rate regime will be the US Treasury. Even if debt does not increase further relative to the size of the economy, higher borrowing costs are expected to add 2% of GDP to debt payments annually through 2030.
If that had happened last year, the Treasury Department would have paid an extra $550 billion to bondholders, more than 10 times the amount of security aid the US has funneled to Ukraine so far.
Of course, some of the reasons why interest rates might move higher – such as stronger productivity growth or investment to get to zero emissions – are positive rather than negative. Higher interest rates create winners, but also losers: savers and investors who pile into bonds will enjoy higher rates of return. Also, when a recession hits, the Fed will have more room to lower borrowing costs to stimulate the economy.
Powell once said that the r-star is less reliable than the celestial stars ancient sailors relied on to guide their voyages because its orbit changes so often. That’s exactly what’s happening now – and it’s going to be difficult to navigate.
