R-stargazing: Part two

Summary

In our view, r* probably has risen from the 0.50% or so that prevailed on the eve of the pandemic, but we are skeptical it has returned to the 2.50%–3.00% range that was prevalent before the 2008 financial crisis. Our working estimate for r* is currently 1.00%–1.25%.

Why do we believe that r* has not risen even more? First, labor productivity has not accelerated relative to its pre-pandemic trend. Second, the pace of globalization appears to have stalled out, but it has not fully reversed, at least not yet. The United States continues to run a sizable current account deficit, and the corresponding current account surpluses elsewhere in the world leave foreigners positioned to keep buying dollar-denominated assets in size, including Treasury securities.

Fiscal deterioration is one potential source of upward pressure on r* since 2019. Using the rule of thumb that each percentage point increase in the debt-to-GDP ratio increases long-term rates by two to three bps suggests that r* has increased by roughly 38–57 bps, all else equal, from the growth in U.S. public debt since 2019. However, we believe that at least some upward pressure on the natural rate from fiscal deterioration has been offset by structural demographic trends, namely the aging of populations in the U.S. and elsewhere.

The behavior of the U.S. economic data since the FOMC started tightening monetary policy backs up the idea that the current stance of monetary policy is restrictive, i.e. the policy rate is currently above its neutral equilibrium. The yield curve has been inverted for two years now, including shorter-dated maturities that are less influenced by term premium effects. Inflation in the United States has slowed considerably since the FOMC began increasing the federal funds rate, while the labor market is no longer as hot as it previously was.

Although r* may still be low by historical standards, we think there is a more plausible case that it may rise further in the years ahead. The outlook over the next decade is naturally more speculative, but we think the risks are clearly tilted to the upside for r*. This is in sharp contrast to the 2010s, when the risks to r* were perpetually skewed to the downside.

Labor productivity may accelerate in the years ahead as the impact from generative AI is slowly felt across the broader economy. Geopolitical tensions and protectionism are on the rise, and a steady slide and/or a sudden shock on this front could lead to a higher r* if FX reserve managers, sovereign wealth funds and foreigners more broadly pull away from the U.S. Treasury market.

The daunting federal fiscal outlook is another potential source of upward pressure on the natural rate, and a lack of action from Congress and the president could lead to a higher r* and, by extension, higher rates more broadly in the years ahead.

Is a return to r* values in the 2.50%–3.00% range possible? We believe it is possible, just not probable. The outlook for variables such as new technologies and geopolitics is highly uncertain, and demographic headwinds likely will exert a structural downward pressure on r* in the years ahead under all scenarios. As a result, we think a 2.50%–3.00% r* value is more of a tail risk than a base case, with 1.50%–2.00% perhaps more realistic.

Download The Full Special Commentary