As the world’s central bankers meet at the annual conference held by in Jackson Hole, Wyoming this weekend, one question is paramount. Have interest rates peaked, and if so when might they start to decline? A speech on Friday by US Fed chairman Jay Powell will be closely watched for clues – the message he may bring is that US interest rates will have to stay “higher for longer” to ensure inflation is tamed. This does not necessarily mean they will rise further, but he will try to persuade the markets that reductions are a way off yet. In Europe, views in the market are split almost 50:50 on whether the European Central Bank (ECB) will increase interest rates again at its meeting in September. Inflation is falling on both sides of the Atlantic, though growth indicators seem stronger in the US, pushing up longer term interest rates this month. In Europe, there are fears for the larger economies, particularly Germany.
Underlying this debate on the short-term outlook is uncertainty about where central banks’ rates are heading in the long term and what, in future, will be the ‘natural’ rate of interest – the level which neither stimulates nor contracts the economy. This is a key reference point to gauge the stance of monetary policy and a vital long-term indicator for borrowers.
1. The theory
The natural rate of interest (known by economists as r*) is always a matter of debate for one simple reason – it can never be observed in the data. It is always an estimate, a best-guess if you like, and it changes over time. It is generally expressed in real terms, in other words it is related to the rate of inflation. ECB chief economist Philip Lane has said it is the rate which equals to a neutral policy stance: “this corresponds to a situation in which the economy is operating at potential and inflation is at its target value, such that there is no reason for the central bank to inject or withdraw stimulus.”
If we assume that the current bout of inflation, caused by unprecedented factors, will fizzle out and that the ECB will succeed in getting inflation down to its 2 per cent target, an interesting question is what would then be a rate of interest which would neither stimulates nor contracts the economy. This would then at least give borrowers some guidance as to what rates would be on average over a 20- to 30-year mortgage term, even if the variation around this average would be impossible to predict. And we know from the period after the great financial crisis how a long period of out-of-line inflation – in that case very low – can significantly affect the nominal rates we all pay. With inflationary pressures and growth very weak during that period, ECB rates fell to zero – and below during Covid – and so mortgage borrowers had a period of super-low rates, with many trackers priced in the 1 to 1.5 per cent range.
2. The history
Since the 1980s, interest rates in developed economies have been on a firm downward trend – at least up to last year when central banks started to respond to soaring inflation. After the financial crisis, in particular, they slumped to particularly low levels. This saw economists debating both the impact of shorter term factors and an apparent increase in the natural rate of interest. Why did this happen?
In a 2019 paper, Lane points to three key factors. The first is a lower potential growth rate in developed economies – in other words they can only sustain lower growth rates without triggering inflation. This relates to trends in productivity and also the diffusion of technology; one reason is a shift in activity in developed economies from manufacturing to services, where productivity growth tends to be lower. The overall impact of these trends is dramatic – estimates of the potential growth rate in the euro zone have fallen from 4-5 per cent in the 1970s to perhaps under 2 per cent today. Slower growing economies require less investment – and thus need less savings to fund this investment. And so interest rates, which encourage savings, can be lower. Lane points to uncertainty about potential growth rates in future, as digitalisation advances and AI and other trends take hold.
The second factor is a generally ageing population across the developed world as fertility rates fall and people live longer. Ageing is associated with higher savings – thus providing funding for investment. And Lane also points to studies showing lower investment is needed in populations which are lower. Again this requires lower interest rates as the demand for savings to fund investment is lower. And the third factor, pushing in the same direction. is the move of more assets from risker areas such as shares to safer havens such as bank deposits, where they are available to fund lending for investment.
Overall, Lane concludes that before the pandemic hit, the natural real rate of interest in the euro zone was zero or negative. In other words, ECB rates would need to roughly equal the rate of inflation, or perhaps be slightly lower. With inflation negative in the euro zone for periods after the crash and rarely much above 1 per cent, this meant the ECB refinancing rate from which tracker loans are priced was 0 per cent from March 2016 up to summer 2022. When inflation is that low it causes problems for central banks, who struggle to move rates far into negative territory (the separate ECB deposit rate was in negative territory for this period).
3. Where are we now
If the natural real rate is still zero, or even slightly negative, it gives us some basis on which to work out where interest rates might be in the long term. It would mean, for example, that if the ECB achieved its target of reducing inflation to 2 per cent, then its policy interest rates might, on average, be around the same level. But whether the surge in inflation has pushed up the natural rate – or will at least require the higher for longer tactic to shake inflation out of the system – will be a key debate in Jackson Hole. What the US does here will matter, worldwide. Powell, the Fed chair, speaks against a backdrop of some resurgence in US economic growth, but ongoing nervousness about the international outlook and about financial stability. With US Fed rates already over 5 per cent, Powell may signal that they have gone high enough, but may have to stay there for some time. Part of this is to make sure inflation is defeated, but part is a fear that the natural rate in the US may be creeping up – researchers in the New York Fed, however, still feel that if inflation is at 2 per cent, the appropriate rate would be around 2.5 per cent.
In Europe, ECB chiefs have previously hinted that the natural rate would be around 2 per cent, assuming the 2 per cent inflation target is met. However some private-sector researchers have calculated it as somewhat higher at the moment perhaps also around the 2.5 per cent level. or even a bit higher . Looking at financial markets , they are implicitly pricing in around 2.5 per cent as the longer-term ECB rate.
4. What does this mean for mortgage borrowers?
In short, it means that it is very unlikely that interest rates will go back to the super-low levels seen for many years after the financial crash. However it does mean that if the ECB succeeds in bringing down inflation, then over time tracker interest rates should fall significantly enough and fixed rates for new borrowers should edge lower too – they have not so far increased to fully reflect rate rises.
At the moment the ECB deposit rate – its key rate – is 3.75 per cent and the refinancing rate is 4.25 per cent. We must wait to see if there is another tick upwards in September. In the longer term, we might expect the refinancing rate to fall back to 2- 2.5 per cent, which would bring the refinancing rate, the key for tracker holders back to 2.5 - 3 per cent. This would leave most tracker rates in the 3.75 to 4.5 per cent level. A period of weaker growth could knock a bit more off this.
This is what a “normal” interest rate might look like. Not as good as it was for the years after the financial crash, but better for borrowers than it is now.
