Interest rates will fall sharply over the coming year. But where will they settle?
THE central bankers landed in 2024, without too much trouble and with little tremor. Gloomy predictions that only deep recessions could bring soaring inflation back to earth have proven wrong. Instead, a sharp increase in interest rates, supply-side improvements, and the passage of time have done the job well enough. Inflation is at or near 2% in all rich countries and, barring trade wars or other shocks, it should remain low. The economic news in most rich countries is rather sunny. Growth varies from strong to very weak, but at least it is not negative. Stock prices are still higher than ever. The unemployment rate is just above its historic low.
Mission accomplished, then? Almost. The economy may be back to normal, but economic policy is not. Interest rates are at their highest level since before the 2007-2009 financial crisis. Most central banks, including the Federal Reserve, the European Central Bank and the Bank of England, did not begin cutting rates until the summer or fall of 2024. Deeper cuts are planned for 2025. Operators predict additional cuts of around one percentage point in the United States, Britain and the euro zone.
Budget deficits
There are also budget deficits. The US government currently runs a deficit of 6.4%, the highest in post-war history outside of the financial crisis. Donald Trump will not fail to dig into it further. Since the pandemic, many rich countries have controlled their public spending a little better, but deficits are also worrying in France and Italy. The policy will normalize again in 2025.
Monetary policy will evolve more quickly and more consistently than fiscal policy. Central bankers tend to be more restrained and predictable than politicians. What is much less clear, however, is the baseline to which economic policy will return. The last period of economic normality occurred five years ago. Central bankers tend to answer this question in terms of r-star, the “neutral real interest rate”. This is the interest rate that, once inflation is eliminated, neither stimulates nor depresses the economy. Unfortunately, the r-star cannot be observed directly. Rather, economists are interested in how the economy responds to changes in interest rates in reality. If the structure of the economy has changed since the pandemic, the r-star should also be different.
From the 2000s to the 2010s, r-star fell sharply. In the decade since 2010, even ultra-low interest rates have failed to stimulate demand. More recently, the economies of rich countries have resisted even fairly large interest rate increases. Has r-star increased, and will it continue to rise? Jerome Powell, Chairman of the Fed, seems to think so, as do many investors and economists.
There are good reasons for this. Geopolitical tensions, for example, may have caused US Treasuries to lose their safe-haven status. But don’t expect interest rates to be low just yet. In the long run, the main determinant of real interest rates is probably economic growth. Investors can hardly expect high returns in a stagnant environment. The slowdown in population growth is weighing on the workforce. Growth figures have been upended by the covid-19 pandemic, but most rich countries have returned to their pre-pandemic trend or slightly exceeded it. People who expect to live longer are likely to save more, which stimulates the supply of capital in search of yield-generating investments. This phenomenon also puts downward pressure on the r-star.
The economy may be back to normal, but economic policy is not.
Like in 2010
When interest rates continue to fall through 2025, the r-star will help determine where they will settle. Other factors could be involved. Rates may need to stay higher for some time to offset larger budget deficits if, for example, governments increase defense spending to guard against growing U.S. isolationism. And if the world is now more prone to supply shocks, rate-setters may need to tighten the range to avoid inflation.
But if we think in the long term, the r-star is inevitable. A weaker r-star than expected could cause problems. One reason Americans have been optimistic about recent labor market turmoil is that the Fed still has plenty of room to ease policy. But if the neutral interest rate is lower, rate cuts will also have to be significant for monetary policy to become stimulative. None of this should worry us yet.
An immediate recession does not seem likely. But the further rates fall, the more likely it is that monetary policy will start to resemble the 2010s again.
By Archie Hall, economic correspondent in Great Britain for “The Economist”
