In New Demographic Era, Do Policy Interest Rates Even Matter?

Investors will watch intently as the Fed decides whether to cut interest rates to defend against a feared coming recession. Wall Street broadly expects the Fed to announce a rate cut when it meets July 31.

But increasingly, many economists say it may not matter that much what the Fed does. The economy is what it is because of demographics.

For a couple of years, macroeconomists have increasingly suggested that changing western demographics – people living longer and fewer babies being born – have made central banks less and less able to affect the economy through manipulation of interest rates.

The Natural Interest Rate

Some central bankers see a sea-change when they look at monetary policy possibilities because of new observations about what’s known as the “natural interest rate,” or the “equilibrium rate,” or, in economist-speak, “R-star.”

Those are all terms for the real short-term interest rate that would be expected to prevail when the economy is at full strength, when monetary policy neither boosts nor hinders growth. It’s just what it sounds like – the interest rate lenders would charge in natural conditions, without the Fed influencing it. They're kind of theoretical - because the Fed does influence rates. 

Economists and central bankers have noted for a couple years now that assumed natural interest rates have stayed incredibly low for several years, which is far lower than they were for decades, and lower than many thought likely.

What’s Changed? Population

“Shifting demographic trends and a slowdown in productivity are driving slower trend growth and historically low levels of real interest rates across the globe,” New York Fed President John C. Williams said at a speech in May at a montetary conference in Switzerland.

Lower Potential Output

People are living longer, but population growth is slowing to a standstill because people aren’t having many children.

Williams noted in his speech that in OECD countries population growth is now about a half percent a year, half what it was in the 1960s, and is expected to be negative by 2070.

That reduces the potential output of the economy because it means the part of the population that produces that output (the young) is smaller. The part of the population out of the workforce (the old) is getting bigger. Fewer workers means lower potential output, which means a lower natural rate of interest.

In April, the St. Louis branch of the Fed highlighted the change and reached the same conclusion. It noted that the U.S. natural rate of interest, around 6% in the early 1960s, dropped dramatically during the 2007-09 recession and never went back up.

“Most likely, changing U.S. demographics are reducing the U.S. natural rate of interest by decreasing potential output,” the paper said.

The Trends

Economists have noticed the effect of the demographic shift for a few years. A paper published back in 2016 by the Fed’s research division suggested that “low investment, low interest rates and low output growth are here to stay,” because of the demographic change – and that the U.S. economy was entering a “new normal.”

It is, says Williams – and many others – likely the way things are just going to be.

“Investors view these low inflation readings not as an aberration, but rather a new normal,” Williams said. “This new set of facts requires us to rethink what we once knew, reassess how to best foster strong and stable economies, and ready ourselves for the future.”

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