Naoum: Today, we'll be talking about interest rates. This is not a podcast about our tactical view of interest rates or an opinion piece on some recent central bank action. The topics are heavily covered by many media and research outlets. I want to talk about that natural rate of interest. Basically, what is the level of policy interest rates that will neither choke the economy or create asset bubbles? I want to focus on the equilibrium level of interest rates. Thanks for joining us today. My name is Naoum Tabet, Managing Director at TD Asset Management. And with me is Alex Gorewicz, a member of the Fixed Income Team with extensive experience in everything rates related. So that concept of an equilibrium level of interest rates has been modeled and tracked for a very, very long time, I think going back to the 20th century. It gained a lot of prominence in the early 2000s through the work of the Federal Reserve chair and since been quoted many times. The terms used to quote the equilibrium level of interest are R-star, natural rate, and neutral rate. Bottom line, it all means the same thing. It's the policy interest rates that will never choke that economy or create those asset bubbles. So let's go into the theory. It states that there's a certain level of impact on the equilibrium level of interest rates that comes from long-term economic factors. The two main factors that drive it are productivity, firstly, and then secondly, demographics. Because productivity levels and demographic trends obviously change with time, this results in equilibrium level of interest rates that is not constant over the long term. What do I mean is, it can be that that equilibrium level is at 5% during a period or 1% over another period. So interest rate levels that neither choke the economy nor create bubbles changes through time. So I earlier said that there's two main factors that drive the equilibrium level of rates-- productivity and demographics. Thinking about it, how productivity impacts that equilibrium rate, well, to have the details around the mechanics of it, there's a paper attached to this podcast. But the bottom line is R-star rises when productivity increases materially. Think the invention of the computer. And it declines if nothing significant happens to productivity. Think the last 10 years. So the lack of significant productivity growth over the last decade has really put downward pressure on the equilibrium rate. And likely, it could continue for some time. The other major factor that drives that equilibrium rate is demographics. So as the population ages, obviously, it would look to save for retirement and take less risk with their savings. You know, you're retired, you don't have that income stream. They will park money in government bonds and money market, which really increases the demand for those safe assets, be it fixed income assets. So an aging population means more people want to lend money to the government, which will drive that equilibrium level of rates lower. Well, I don't expect any material slowdown in the aging population. And we believe that downward pressure on that equilibrium rate will continue. So far, we talked a lot of theory. Now we're going to ask the question to a practitioner. Now, turning to you, Alex, what's your view on that neutral level of interest rates or that equilibrium level?
Alex: Naoum, while I agree that productivity and demographics are the key drivers of that R-star in the longer run, I think over the next couple of years, there's a lot of uncertainty around other policy angles that have the ability to change the perception around those two key factors-- things around fiscal policy, social policy, or geopolitics. And I think all of this uncertainty will exert upward pressure on R-star versus where it was for much of the 2010s. So if we agree with the Fed that over the last decade, R-star was, in nominal terms, around 2 and 1/2% to 3%, then I think over the next couple of years, we'll probably see a shift higher of about half a percent to even a full percent-- so 3% to 3 and 1/2%. Couple of things-- to me, the ballpark level matters more than the precise measurement itself because it's impossible to know where that true rate really is. But it's not useful on its own as a measure. It's a relative gauge for monetary policy. So if the Fed, as of the time of this podcast, is at 5.5% policy rate, even if my R-star is higher than the Fed at 3 and 1/2%, I still think monetary policy is tight. And then, of course, my view can also change if some of those medium-term uncertainties dissipate.
Naoum: Is there a possibility that interest rates stay high at the level that they are today?
Alex: I think it is. And it's around this perception of R-star, which actually anchors interest rates, especially longer interest rates like 10-year and 30-year rates. So I told you that my view is 3% to 3 and 1/2%. Collectively, the market or collectively, investors think it's actually closer to 4%. But the Fed is still at 2 and 1/2%. And if there is a meaningful change that we've seen this year, is that every update in the dot plot that the Fed puts out every quarter, we've seen more and more Fed members skew upwards their views on R-star. I'd say if the median view changes to be closer to where, let's say, I am or where the market is, I think that will prop up interest rates around today's elevated levels.
Naoum: Let's think about it from an opposite direction perspective. What would push interest rates to go extremely low or even negative?
Alex: Well, I'm a creative person, so I could come up with a couple of scenarios. But I'll try to summarize that in a couple of factors that could bring R-star back down. I'd say one is-- I'll call it a permanent destruction of capital. So let's say there are a lot of debt defaults in our economy from any economic actor-- households, corporates, or governments-- with little to no recovery rates. If there is a structural shift higher in the savings range-- so the propensity to save more increases, or if there is some kind of sustained deleveraging cycle, I think any one of these three could exert downward pressure on R-star.
Naoum: Thanks Alex, maybe you could just give us a sense of the methods you use in forecasting interest rates over the short and medium term. What do you consider? What do you look at? How do you model it? How do you think about it?
Alex: Probably two key ways. So one is based on something called pure expectations theory for interest rates. It's basically where we create a path of where we think in the future the Fed policy rate will be. And then we compute 2-, 5-, 10-, 30-year rates under that path, and then we compare with where interest rates are today. But of course, we have to do this analysis over multiple scenarios because we have to assume Fed policy path will be different depending on what happens in the economy. And then another method is to effectively use statistical modeling techniques to compare today's interest rates against a really wide array of fundamental or economic variables as well as financial market variables.
Naoum: It seems that everybody and anybody has an opinion on the level of interest rates, from my dad, to my friend who's trying to decide to fix or keep his mortgage rate variable. How complex is the forecasting process, or how complex is it to forecast interest rates?
Alex: I wish I could give you a succinct answer because then it would be easier to answer all those mortgage questions I get as well. Should I go variable or fixed? But really, it's a multilayered process. It involves a lot of data, a lot of models, numerous people or probably put a wide array of expertise. And the truth is that I kind of simplified my answer to your previous question about how we forecast interest rates because actually, interest rates have multiple components, and each one of those components has to be dissected, understood, and modeled. What I mean by that is like, if you take a 10-year rate, for example, it can effectively be broken down into three components. You have 10-year inflation expectations, you have 10-year real rates, and then you have the 10-year term premium. And if I was to get really geeky, you could actually take that 10-year term premium and split it up into term premium for inflation expectations and for real rates. So it's actually four components, if you will. But for each one of these components, we have to find data, clean it, store it from multiple sources probably. It comes in multiple dimensions, different data types, different frequencies, et cetera. And then we have to create appropriate models that or apply various statistical techniques for each of these components depending on the data inputs that we use. So the forecasting process actually requires a lot of data collection, a lot of data processing and analytics capabilities. But then beyond that, we actually have to engage with different investment peers across our firm and across asset classes so we can debate, we can stress test, we can discuss the validity of the results of all of these different models. And we don't just do that within fixed income where, yes, we have a lot of fixed income experts across the portfolio management teams, the trading teams, the credit research teams, but we also have these conversations across asset classes where, let's say, our asset allocation or equity research peers will also look at different components that are related to interest rates for their specific needs. And if I had to summarize in one sentence, I'd say there's a lot of complexity, a lot of computation, and a lot of collaboration to do the forecasting of interest rates.
Naoum: Awesome. Thanks, Alex. Really, just to summarize, there is a natural level of interest rates, an equilibrium level, that if policy rates are above that, it's looking to slow down or chill the economy, and if it's below that it could possibly create an asset bubble. Maybe that's really what we wanted to highlight in this podcast. But also, we wanted to showcase that that equilibrium level changes through time, and it's not constant, and in addition to that, that forecasting interest rates is extremely complex and requires a lot of tools, a lot of resources, a lot of models, and obviously, a lot of people with that specific experience and expertise. Thank you for joining us today. And, please, open that thought piece inside that podcast and have a read.
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