The importance of CBO’s new interest rate projections
The Congressional Budget Office released its long-term budget projections today. The document shows CBO’s estimates of long-term trends in federal government spending and revenues. But the report also contains the nonpartisan organization’s estimates of a variety of economic variables, among them population growth, productivity, and long-term economic growth. One variable, long-term interest rates, is particularly interesting given the recent conversation about the global savings glut, the “everything bubble,” and secular stagnation. CBO is projecting lower annual interest rates than in the past. Given the importance of trends in interest rates to our financial system, our long-term fiscal outlook and economic growth, this trend shouldn’t go unnoticed.
In its 2013 long-term budget projections, CBO forecasted that the long-run average annual interest rate would be 3 percent. This year’s forecast has lowered that projection to 2.5 percent. This new projection is not only lower than previous forecasts but also lower than the average range of 3.1 over the period of 1990 to 2007. Thankfully, CBO goes through the different factors that influenced their lower projected interest rates. And these factors are interesting in their own right.
The organization considered several factors that might increase long-run interest rates.First is a higher level of public debt, which will crowd out some private investment, reducing the amount of capital per worker and increasing interest rates. Second is a lower savings rate among developing countries as these economies become richer and their consumption will increase, which means less capital flowing into the United States and therefore less capital per worker. Third is the higher share of income going to capital that would boost the return on capital and therefore interest rates. (This last factor sounds familiar to the one presented in Thomas Piketty in “Capital in the 21st Century.”)
Weighing these three factors against others, CBO on the whole finds that interest rates will decline. They point out that in the wake of the financial crisis there is more demand for low-risk assets, which would result in lower interest rates for U.S. treasury bonds. The budget office also notes that lower growth in total factor productivity growth, or how efficiently capital and labor are used to create output, will reduce interest rates for a given rate of investment.
Interestingly, CBO also notes that rising income inequality will increase savings, which helps push down interest rates. Higher-income people save more, so shifting more income toward them would increase overall savings. In fact, they note that the magnitude of this effect is large enough that declining savings from aging demographics wouldn’t offset this inequality induced increase in the savings rate.
The valuation of financial assets and the amount of money the federal government pays back to debt holders are just some of the few important economic factors influenced by interest rates. Understanding how and why this important variable will change over time is vital for understanding how the long-run future of our economic growth and stability.