The Price of Money: The Most Important Price in the Global Economy
What is the most important price in the global economy? Is it the price of oil, semiconductors, or even a Big Mac? Surprisingly, the answer is none of these. The most crucial price is the price of money. For over thirty years, this price was declining, but now it’s on the rise.
Many people may assume that central banks have complete control over the price of money. While it is true that the Federal Reserve governs interest rates in the US, there is a deeper logic at play. Just like any other product, the price of money is determined by the balance of supply and demand. When there is a higher supply of savings, interest rates decrease. Conversely, when there is a greater demand for investments, interest rates increase.
The price of money is also known as the “natural rate of interest,” which is the rate that balances savings and investment while maintaining stable inflation. The significance of this concept in policymaking lies in its ability to predict the outcome of setting borrowing costs below or above the natural rate. If borrowing costs are too low, there will be excessive investment, insufficient saving, and an overheated economy leading to inflation. Conversely, if borrowing costs are set above the natural rate, there will be a surplus of saving, insufficient investment, and a cooling economy resulting in rising unemployment.
Over the past three decades, borrowing costs in the US have been declining. In real terms, the natural rate of interest for 10-year US government bonds fell from just over 5% in 1980 to less than 2% in recent years. To understand what caused this decline and forecast the future of the natural rate, we developed a model that explores the major factors affecting the supply of saving and demand for investment. Our dataset covers half a century and includes 12 advanced economies deeply interconnected in the global financial system.
The results of our study indicate that weaker economic growth was one of the leading reasons for the decrease in the natural rate. In the 1960s and 70s, a growing workforce and rapid productivity gains led to average annual GDP growth of nearly 4%. This robust growth incentivized investment and drove up the price of money.
However, after the global financial crisis in 2007-08, average annual GDP growth dropped to around 2%. This slower economic growth reduced the appeal of future investments, resulting in a decline in the price of money.
Other factors also contributed to the decrease in the natural rate. The aging baby boomer generation, starting from the 1980s, began saving more for retirement, increasing the supply of saving and putting downward pressure on interest rates. Additionally, China’s fast-growing economy and high income inequality in the US further boosted the supply of saving. On the other hand, advancements in technology, specifically cheaper and more powerful computers, reduced the need for companies to invest heavily in upgrading their technology, lowering investment demand and pulling down the natural rate.
These declining borrowing costs had profound effects on the US economy. Low interest rates allowed households to take on larger mortgages, contributing to the subprime mortgage crisis and the subsequent global financial crisis. Furthermore, despite a significant increase in US federal debt, the cost of servicing that debt remained low, enabling the government to continue investing in various sectors.
However, the tide is turning, and the factors that drove the decline in the natural rate are now reversing. Demographic changes, such as the retirement of the baby boomer generation, lead to a decrease in the supply of savings. Additionally, strained relations between the US and China, along with China’s economic rebalancing, have put an end to the flow of Chinese savings into US Treasury bonds. The surge in US debt resulting from the global financial crisis and the COVID-19 pandemic has created greater competition for savings, which, coupled with the Inflation Reduction Act, is pushing borrowing costs upwards.
According to our model, we expect the natural rate to increase by about a percentage point, from 1.7% in the mid-2010s to 2.7% by 2050. This translates to 10-year Treasury yields settling between 4.5% and 5% in nominal terms. However, there is a possibility of even higher borrowing costs than our baseline suggests, considering factors such as continued high government borrowing, increased spending on climate change initiatives, and accelerated productivity growth from advancements in technology.
The shift from a falling to a rising natural rate will have far-reaching consequences for the US economy and financial system. Housing prices, which have been rising for decades, may reach their peak as borrowing costs increase. The same holds true for equity markets, as low interest rates have fueled the continuous surge in equity valuations. On the other hand, savers and bond investors will benefit from higher returns. Additionally, a higher natural rate will provide the Federal Reserve with more flexibility to lower borrowing costs during recessions and stimulate economic growth, partly restoring the lost power of monetary policy. However, after years of declining rates, both the US and the world need to brace themselves for this significant reversal.
