Is There Such a Thing as an Optimal Interest Rate?
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What happened to the lower-for-longer interest rate narrative? It has been sidelined over the past two years as central banks hiked interest rates to rein in surging inflation. But now that we’re seeing a pause in rate hikes, what can investors anticipate in the long run? Or taking it a step further, is there such thing as an "optimal" interest rate?
The R-star
To provide some insight and to help answer this question, TD Asset Management Inc. (TDAM) recently published an article titled Finding Guidance with the R-star’s Light that discusses the concept of the R-star and how it can guide views for long-term interest rate expectations.
The R-star is the level of interest rate when an economy is at full strength and inflation is stable in the long run (the optimal rate). The concept traces its origins back to the early 20th century so it's not a new concept. But the R-star gained in prominence by the U.S. Federal Reserve (the Fed) in the early 2000s and has since become a widely used data point for interest rate expectations.
The trend
Over the last 20 years the modeled optimal rate of interest has been declining, but the formula isn’t that cut and dry either. The absolute level of optimal rate isn’t hugely important as that number fluctuates through time. For example, a real policy rate of 3.5% in 1999 can be expansionary, while a real policy rate of 1% in 2015 can be contractionary which may seem counter intuitive. The reason this occurs is simple: the R-star is independent of a central bank’s direct control; instead, it is driven by long-term economic factors like productivity and demographics and medium-term financial drivers like capital flows.
Over the last two decades, the R-star in the U.S. and Canada has been declining as productivity growth has shrunk and the population has aged materially. The decline in productivity growth can be attributed to the fact that technology has been widely adopted and the scope for rapid gains has diminished when compared to the internet boom and the post-World-War-II era.
At the end of 2023, as central banks are seeking to quash inflationary pressures, the real Fed funds rate is at around 1.8% versus an R-star of about 1.3%. This can be defined as a contractionary monetary policy environment.
The outlook
We at TD Asset Management Inc. feel that the R-star in Canada and the U.S. will remain unchanged and stay between 0 and 2%, which is where it has been for the last 20 years. This is assuming that demographic trends are unlikely to reverse their course as the population will continue to age for decades to come. However, there is one caveat. Because the demographic transition is already well entrenched, the demand for safe assets will continue to increase, but the pace of the increase will moderate and the downward impact on the R-star will be less pronounced. Predicting the future is always tricky. But for investors seeking direction on where long-term interest rates will go, considering the R-star concept can be helpful, especially since short-term fluctuations don’t impact the long-term outlook for the optimal interest rate.
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