Ever since the global financial crisis, the real interest rates of developed economies have remained in negative territory. Nominal interest rates hover near zero, and inflation rates, although quite low for historical standards, have remained positive (in most countries, at least on average). What’s more, negative nominal interest rates have even been observed in some developed countries for the first time.
The typical explanation for these low real rates is the extremely loose monetary policies (qualitatively, through lowering interest rates, and quantitatively, through bond-buying programs) put into place in response to the crisis. In the past several years, many of Wall Street’s gurus have persistently warned that the low-rate environment will soon be over and central banks will begin the tightening cycle.
A Study Of Demographics And Interest Rates
Carlos Carvalho, Andrea Ferrero and Fernanda Nechio—authors of the September 2015 paper, “Demographics and Real Interest Rates: Inspecting the Mechanism”—have a different perspective.
The authors begin by noting that real interest rates have been trending down for more than two decades across many countries, suggesting that there are forces other than accommodative monetary policies at play. Their hypothesis is that demographic trends offer at least a partial explanation for low and declining real interest rates.
They note the world is undergoing a dramatic demographic transition, and write: “In most advanced economies people tend to live longer. In Japan, the U.S. and Western Europe, life expectancy at birth has increased by about 10 years between 1960 and 2010, and new generations have continued to expect longevity to increase. At the same time, immigration notwithstanding, population growth rates are decreasing at a fast pace, and in some cases (e.g. Japan) becoming negative. The combination of the population growth slowdown and the increase in longevity implies a notable increase in the dependency ratio—i.e., the ratio between people 65 years and older and people 15 to 64 years old.”
According to the authors, consequences of this demographic transition are far-reaching and result in important macroeconomic, public finance and political economic repercussions. They develop a life-cycle model that captures important features of this demographic transition in developed economies, and then predict the real interest rate. Following is a summary of their findings:
- The overall effect of a prototypical demographic transition is to lower the equilibrium interest rate by a significant amount.
- In response to the demographic transition, the equilibrium real rate declines by 1.5 percentage points, to 2.5%, in the study’s “representative developed country” between 1990 and 2014.
- The model explains about one-third of the overall decline observed in the data since 1990.
- The increase in the probability of a person surviving longer, rather than the fall in the population growth rate, is mainly responsible for the decline in the real interest rate explained by the demographic transition.
- The model predicts that real interest rate will fall an additional 50 basis points over the next 40 years before stabilizing around its new steady-state value of 2%.
The demographic transition, and in particular the higher probability of surviving, does not carry large consequences for macroeconomic aggregates. Rather, the real interest rate bears the bulk of the adjustment. In the aggregate, consumption falls by about half a percentage point.
Impact Of Falling Population Growth Rate
The authors show that another notable aspect of the demographic transition is the fall in population growth rate. However, they found that the repercussions this has on the real interest rate are quantitatively less significant than the increase in life expectancy....