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Recent financial market trends suggest that interest rates may not only remain high in the near future, but potentially indefinitely. With the resurgence of inflation, the era of ultra-low rates appears to be over. One of our financial analysts has noted that markets are now reflecting a scenario where the neutral interest rate, or ‘R-star’, is also on the rise.

Traders predict U.S. rates to hover around 4% by the end of the decade, significantly exceeding policymakers’ 2.6% long-run expectations. Similarly, euro area rates are projected to reach approximately 2.5%, surpassing the levels observed for most of the bloc’s history.

Accurately predicting where rates will settle poses a considerable challenge for policymakers and investors alike. Many economists believe R-star is lower than pre-financial crisis levels, yet there is disagreement on how to calculate it, its current level, and whether it’s increasing.

One of our economic analysts expressed concern that the potential rise in R-star hasn’t been fully factored into equity and property markets.

Key Factors Influencing Long-Term Interest Rates:

1. The Cost of Financing:

   • Extensive investment requirements, encompassing climate initiatives and military expenditures, coupled with rising interest costs, will sustain high government borrowing.
   • Economists are debating the effects of increasing debt, but some anticipate spending needs will drive rates upward.
   • Advanced economy budget deficits, estimated at 5.6% of output in 2023, were nearly double the 2019 figure of 3% and are projected to remain elevated at 3.6% in 2029.
   • An analyst suggests that higher deficits could lead to increased premiums demanded by investors for holding government bonds.
   • However, the slowdown in productivity gains and subdued potential growth on both sides of the Atlantic could dampen investment, potentially mitigating the increase in neutral policy rates.

2. Aging Populations:

   • Demographics represent a significant uncertainty for longer-term rates.
   • A consensus exists that a savings glut, fueled by pre-retirement hoarding in wealthy nations, has contributed to suppressing rates.
   • This trend might persist, as projections indicate that 16% of the global population will be over 65 by 2050, compared to 10% in 2022.
   • However, the rising ratio of dependents, including retirees, to workers could lead to higher rates due to age-related spending reducing saving.
   • Addressing pension shortfalls through borrowing could also exert upward pressure on rates.

3. The Impact of Climate Change:

   • Assessing the economic consequences of climate change is another major challenge.
   • The green transition necessitates substantial investment, potentially raising rates.
   • The physical impacts of climate change also pose risks of higher inflation and price volatility.
   • These impacts could potentially reduce global output by as much as 17% by 2050, threatening productivity and possibly lowering R-star.
   • On the other hand, more expensive clean energy might eventually decrease investment demand and, consequently, rates.
   • The overall effect of climate change on rates remains a subject of ongoing debate.

4. The AI Revolution:

   • The extent to which technological advancements can boost productivity and rates is a topic of intense discussion.
   • An AI-driven productivity surge could potentially raise U.S. economic growth by 0.4 percentage points and 0.3 points in other developed economies by 2034.
   • This could lead to upward pressure on rates, particularly if AI adoption is accelerated.
   • If the impact of AI is comparable to that of electricity, growth may offset demographic pressures.
   • However, if its impact is similar to that of computers and the internet, it might not meet expectations.

5. Additional Considerations:

   • Geopolitical tensions, deglobalization trends, and changes in monetary policy frameworks are among the other factors that could influence the trajectory of interest rates in the long term.

In Conclusion:

The future of interest rates is uncertain, with various interconnected factors influencing their direction. While the era of ultra-low rates seems to be behind us, the precise level at which rates will settle remains a subject of ongoing analysis and debate among economists and financial experts.