Demographics may tip the balance between uncertainty following Donald Trump’s election as president versus certainty of rising interest rates in the US.
According to a research paper by Gavyn Davies, co-founder and chairman at Fulcrum Asset Management, demographic changes are an important factor to consider when assessing the potential scale of central bank rate hikes – such as the latest seen from the US Federal Reserve.
In theory, he notes, rates should be determined by the abstract notion of an equilibrium rate, the point at which demand for money equals supply. In practice, the equilibrium rate appears to be just as hard to pin down as its sibling, the equilibrium price, which according to Say’s law, is reached where supply meets demand.
Yet both are subject to individual or short term political considerations. Consequently, a long-term indirect factor such as demographics has historically received little attention when considering interest rate levels, Davies points out.
But given the prospect of central bank interest rates across developed markets rising for the first time in nearly a decade, the topic has gained interest, with a growing number of Federal Reserve- and Bank of England scholars arguing that demographic changes, in particular the general increase of age levels across the Western world since the 1980’s have led to a gradual reduction of the equilibrium interest rate.
At the heart of the argument is the notion that savings and investment levels are not static concepts, but change depending on the demographic composition of the country in question, with age affecting both savings behaviour and labour supply.
According to Davies, several key demographic factors have shaped the gradual reduction of the equilibrium interest rate.
First, a general decline in the growth rate of labour supply, which in turn makes capital relatively abundant compared to labour thereby reducing the rate of return on capital.
Second, over the past decades, the dependency rate, the rate of very young or old people compared to the overall workforce, has been relatively low due to the baby boom generation contributing to the workforce. A low dependence rate in turn means a higher savings rate and therefore further downward pressure on rates.
However, as Davies rightly points out, this downward trend is likely to be reversed in the near future as a growing number of baby boomers start to retire.
A third factor affecting the gradual decline of equilibrium interest rates is according to Davies the general improvement of life expectancy, with a growing number of people having to save more money while they are in employment, thereby increasing the savings ratio further.
Davies is by no means alone in his assessment, with Bank of England scholars Lukasz Rachel and Thomas Smith arguing that the equilibrium rate has declined by 1% over the past 30 years, while Carlos Carvalho and others estimate a 1.5% decline over 26 years and Joseph Gagnon and others a 1.25% decline over 36 years.
Overall, there appears to be growing scientific consensus that the equilibrium rate tends to decline, but to what extent demographics have been a decisive factor remains questionable.
Davies’ research fails to acknowledge the fact that today’s record low interest rates are an invention of the post 2007 era. In order to put things into perspective, it is worth considering that throughout the 1980’s, US Fed Funds rates reached levels of up to 20% and were still at 5% immediately prior to the 2007 crisis.
Nevertheless, demographic changes could become an important factor in understanding why, despite a gradual increase of rate levels, interest rates might not reach pre- 2007 levels again for a very long time.