Modeling the decline in U.S. interest rates

A trend as important and complex as the long-term decline in interest rates is going to attract multiple explanations, with many economists eagerly offering up their own recent models in search of answers. Understanding why interest rates have declined so much may help us understand where interest rates will head and how policy might boost the natural rate of interest. A recent paper that builds a model of secular stagnation points toward changes in demographics and declining productivity growth as the major culprits behind the decline in U.S. interest rates. But it might be worthwhile thinking through the decline in interest rates in a different framework.

A model like the one used in a paper by economists Lukasz Rachel and Thomas Smith of the Bank of England thinks of the interest rate as being determined by the interaction of desired investment and desired savings. Think of a supply-and-demand graph where the upward-sloping curve is desired savings, or the supply of savings, and the downward-sloping curve is desired investment, or the demand for savings. The horizontal axis here is savings as a share of gross domestic product and the vertical axis is the interest rate.

The Rachel and Smith paper finds that the decline in the global interest rate of interest is due about equally to a decline in both desired savings and desired investment. The result is a lower interest rate, but with no significant change in the savings as a share of gross domestic product.

But note that the analysis is just for the global interest rate. In their paper, Rachel and Smith show how the trends are slightly different for high-income countries and emerging economies. Both groups of countries saw interest rates decline, but savings as a share of GDP increased among emerging economies while declining among high-income economies. If the price and the quantity of something is down, then this means that declining “demand” (in this case desired investment) has shifted more than “supply” (desired savings). The trend holds up for the United States specifically as interest rates and investment and savings as a share of GDP have both trended downward since the 1980s.

Increased desired savings are likely to play a role as well as the U.S. population has aged. There also is the possibility that increased income inequality, particularly the rise of the top 1 percent, has increased desired savings, according to a paper by economists Adrien Auclert at Stanford University and Matthew Rognlie at the Massachusetts Institute of Technology. Increases savings by corporations also have also contributed to a shift in the savings schedule.

But if the decline in desired investment is at the heart of declining interest rates in the United States, then it may be more worthwhile to dig into the causes of that trend. One potential cause– highlighted by Rachel and Smith’s analysis – is the declining relative price of investment goods. If investment goods are less expensive, then companies will need to spend less for a given investment project. The result is that there’s a downward shift in the schedule for desired investment.

A second potential cause is the increased spread between the risk-free interest rate (the rate of the presumed safest asset) and the return on capital. This higher difference means that a decline in interest rates is less likely to reduce the required return on investment and spur investment. The result is less investment for every given interest rate level, or a downward shift in desired investment.

The reasons behind the increased interest rate spread are not completely understood, but a recent paper by Ricardo Caballero of MIT, Emmanuel Farhi of Harvard University, and Pierre-Olivier Gourinchas of the University of California-Berkeley tries to sort of the causes. The three economists find an increase in risk premiums, meaning that investors want to be compensated more for investing in riskier projects. They also point out that other factors, such as increasing economic “rents” (excessive profits) and technological change that favors capital, may also be contributing to the increased spread and declining interest rates.

Of course, slowing economic growth also could be responsible for declining investment as accelerator models of investment would indicate. But it’s not clear what the relative importance of these factors are for the United States. Better understanding how much desired investment is declining in the United States and what’s behind that trend can help policymakers not only boost short-term growth and boost productivity, but also give them greater insight into what might reverse the decline in interest rates.