Households and businesses were eagerly awaiting interest rate cuts by the world’s major central banks as a much-needed “breather” in an economic environment that, after two years of explosive inflation, now faces the threat of recession.
The ECB acted first and the Fed followed with a gradual tapering. But to what extent will policy be eased? And especially by how much? Capital Economics attempts to answer this question with its analysis.
The cycle of interest rate cuts, he estimates, will not last long, but will be completed next year. And in the coming years we may see the cost of borrowing rise again. The era of abundant and cheap loans, of zero or even negative interest rates, is irrevocably over.
What central bankers are “looking for” is the so-called equilibrium interest rate. What is it? A level of debt that will, on the one hand, prevent inflation from rising, but on the other hand, will not plunge the economy into recession or increase unemployment. Over the next decade, this interest rate in the developed world will be close to 3% to 4%, and not zero, as we were used to for more than a decade after the 2008 financial crisis.
Why do we care about the 10-year interest rate situation? Because home loans or large business loans are not short-term. And the borrower should have an idea of where to find the floating interest rate and whether it is in his or her best interest to choose a fixed rate.
Where will the interest rate be set?
Based on today’s data, Capital Economics estimates that the current rate-cutting cycle will take the eurozone’s policy rate to 2.5%, the UK’s to 3% and the US’s to 3.25% by the end of 2025. A few years of stability will follow, while long-term interest rates will rise again in the late 2020s and early 2030s.
Financial markets appear to agree, with US 10-year bond yields holding steady at around 4% over the past year and German bond yields at around 2.5%.
The fundamental forces that will push interest rates higher between 2029 and about 2035 are as follows:
- Potential GDP growth will be boosted by a rebound in productivity growth as advances in artificial intelligence bear fruit. In fact, productivity growth in the US has already picked up strongly, to 2.9% annually in the first quarter.
- The AI boost will partially offset the pressures on GDP from population aging. As the share of people over 65 in the population rises rapidly, total savings are likely to decline. This is also a factor that will push up the equilibrium interest rate as more people retire.
- And while desired savings will decline, desired investment should increase. Both artificial intelligence and the green transition will play an important role. Another Trump presidency in the US would certainly slow down the green transition, but it could well mean greater incentives and a more favourable tax framework for other types of investment.
By the mid-2030s, Capital Economics estimates that real interest rates in advanced economies will have risen slightly further, to between 3% and 4%, with inflation held close to the 2% target.