When we talk about interest rates, we are often referring to the short-term interest rates set by central banks around the world that affect the cost of the mortgages and loans that we take out.
But there is another kind of interest rate you might not be as familiar with, one that is integral to helping central banks set these short-term rates of interest.
The natural rate of interest, or R-star, represents the level of interest rates needed to be set by a central bank to ensure the economy runs at full capacity and inflation is kept at its target level.
According to Jupiter Asset Management’s multi-asset fund manager Rhys Petheram and value equities fund manager Alastair Gunn, R-star is determined by slow-moving structural factors that alter the demand for capital and the supply of assets.
“Although central banks can set the short-term interest rate, it is longer-term structural factors beyond their influence that determine the natural rate of interest,” they said.
The managers added: “If too low, destabilising excesses build up; if too high, recessions are triggered. It can be viewed as akin to the long-range weather forecast that underlies the daily rain and shine.”
The importance of R-star is that it is used by central banks as an anchor to set their interest rates against and with some investors fearful that central banks, and particularly the Federal Reserve, may make a policy mistake that could lead us into the next recession, it might be a good time to look at an important factor driving their decision making.
There is strong evidence that R-star in developed economies is lower than it used to be and will likely remain low despite a strong global economy, the pair said.
Four reasons are behind this belief that interest rates will remain lower, the first being demographics.
Source: World Health Organization
“People are living significantly longer than just a few decades ago and therefore need to save more for retirement,” said Petheram and Gunn.
“The rise of defined contribution schemes and auto enrolment are also channelling money into financial assets (the global savings glut), putting downward pressure on interest rates.”
The second reason is a slowing labour market in the developed world, which has resulted from lower fertility rates and more retirees.
The managers said: “With fewer people producing and consuming things, economic growth is slower and there is less investment. This reduced demand for borrowed capital also drives R-star down because trend growth rates are lower.”
Thirdly, slower productivity is reducing investment from companies, which is having a knock-on impact on wage growth – something that JP Morgan’s Nick Gartside said earlier this week is the biggest issue investors are not talking about enough.
Finally, people have become more risk-averse following the global financial crisis of 2008. Many that had their fingers burned during the crisis have either not invested at all or are more jittery than they were beforehand.
This means that the demand for “safe-haven assets” has increased causing yields to fall and keeping R-star low.
“But the key drivers are an increase in the supply of savings and a lower demand for capital investment itself partly linked to expectations of lower real growth,” they added.
“These demographic factors are unlikely to dissipate soon so the neutral rate is likely to remain low.”
However, the pair caveated that the real rate of interest is only an estimate because there is always a margin of error.
The fact that central bankers cannot accurately measure R-star is one reason why they continually hike interest rates until the economy hits a recession, they added.
“We labour the point because we are increasingly hearing people say too precisely where the natural rate lies. Like a rabbit in a briar patch, it’s in there somewhere, we just don’t know exactly where,” they said.
UK CPI inflation fan chart
Source: Bank of England
Petheram and Gunn believe it is this margin of error that has stopped the Bank of England (BoE) from giving a precise number for R-star in the UK because it doesn’t want to be wrong.
But it did say it thought the number to be around 0.5 per cent real, or 2.5 per cent nominal, while governor Mark Carney said he thought it to be lower than the global range of between 2-3 per cent, according to the pair of Jupiter managers.
They said: “Carney has acknowledged that while we need to adjust downwards for short-term headwinds, as these fade, rates would need to rise merely to maintain the same degree of accommodation.”
Jupiter’s view is that the natural interest rate is higher than what has been incorporated into gilt yields, meaning the yield curve “is not there yet”.
For this reason, the managers said there are some downside risks in gilts, which, paired with tight spreads, mean they are conservatively positioned.
On the contrary, they believe the opposite is true for the US.
“John C. Williams of the San Francisco Fed (who has a specialist interest in R-Star) has a central estimate for the US neutral rate of 0.5 per cent real, or 2.5-3 per cent nominal - which is where the US yield curve is pricing the Federal funds rate to be in 2019 – and one reason we have seen some value in 10-year Treasuries,” said Petheram and Gunn.
But they acknowledged that the Federal Reserve may have to keep raising rates to counter president Donald Trump’s program of fiscal stimulus.
US Federal Reserve dot plot
Source: US Federal Reserve
That said, they believe that if the Fed stuck to a rate-hiking cycle it would be based around a lower natural interest rate than those seen in previous decades.
“And although technology might be a saviour and deliver higher productivity and a higher trend growth rate – we don’t see that happening any time soon,” added the managers.
“What we do know is that it is much lower than before the Great Financial Crisis a decade ago and it is reasonable to ask whether the neutral rate is likely to rise soon or whether it stay where it is. In our view, it stays where it is.”