If someone challenged you to sum up the key trend of the past 40 years in financial markets, you could do so in a single three-word sentence: Interest rates fell.
The long slide in interest rates that began in the early 1980s changed everything.
Most notably, it provided a tremendous boost for financial assets of all types. This wasn’t magic. It was just math. Any investment that promises to deliver a steady, reliable return becomes more valuable as interest rates decline. So stocks, bonds and homes all climbed higher and higher in price as interest rates trudged lower and lower between 1983 and early 2022.
Unless you’re a greybeard, you probably now regard falling interest rates and rising asset prices as part of the natural order of things. Especially since the turn of the century, the steady decline in interest rates has been remarkably consistent.
Until the past year and a half, that is. The Bank of Canada’s key overnight rate has spiked from near zero to five per cent in recent months as policymakers have propelled borrowing costs higher to contain inflation.
So what happens now? Conventional wisdom says the emergency will pass. Inflation will fade and so will the need for higher interest rates. Within a year or so, most people expect we will be back in familiar territory, with the central bank’s policy rate once again sliding down toward the one-to-two-per-cent range.
But what happens if it doesn’t? If interest rates stay higher for longer – maybe even permanently – then investors are going to face a much tougher environment than the one they have grown accustomed to over the past generation.
It’s a possibility that some prominent policymakers and economists are already considering.
In a speech in June, Bank of Canada Deputy Governor Paul Beaudry warned his audience to be prepared for “the eventuality that we have entered a new era of structurally higher interest rates.”
His argument is that many of the forces that helped drag interest rates lower over the past 25 years are now reversing.
Consider demographics. Aging populations in Canada and other advanced economies spent much of the past few decades stashing away money for retirement. Their diligent savings habit helped swell the pool of money available for investment. However, it also dragged down interest rates, since more and more money was competing for the same limited range of investment opportunities.
This process is now running in reverse. Aging populations across the developed world are retiring in large numbers and beginning to spend their accumulated wealth. Everything else being equal, their spending should put a lid on global savings and help push interest rates higher.
Meanwhile, China is no longer growing at warp speed and amassing huge pools of savings that have to find a home in the global economy. On top of all that, the transition to a low-carbon economy is creating demand for large amounts of cash to finance everything from wind turbines to electric vehicle factories.
Put it all together and it seems possible that we may be entering a world where money is once again becoming scarce. If so, interest rates will have to rise to reflect that scarcity.
Granted, this remains a hotly debated issue. Earlier this year, John Williams, the president of the Federal Reserve Bank of New York, told a conference that “there is no evidence that the era of very low natural rates of interest has ended.”
However, recent data tends to side with those who think something has shifted. Notably, the North American economy appears to be doing okay despite the massive increases in interest rates over the past year and a half. Remember that recession that was supposed to happen early this year as rates ticked higher? It’s still nowhere in sight.
One way to explain this odd state of affairs is to assume that the natural rate of interest – the rate that neither stimulates nor contracts the economy – is now considerably higher than it used to be. If so, interest rates may have to go even higher than they are now to slow the economy and push inflation down to the two-per-cent level that central bankers like.
The key question is what happens when inflation is eventually tamed. Will interest rates fall back as quickly as conventional wisdom assumes?
Maybe not. A recent paper from Serkan Arslanalp of the International Monetary Fund and Barry Eichengreen of the University of California, Berkeley, argues that high levels of public debt are now a permanent feature of the global economy. If they’re right, governments will have to convince investors to hold large amounts of government bonds for years to come. The most likely way to do so is by offering higher rates of interest on that debt.
To be sure, any long-range economic forecast is likely to be wrong in some way. Maybe an AI-fuelled boom in productivity, or some unforeseen development, will change everything.
However, investors should at least consider the possibility that interest rates could stay higher for longer than they now expect. “The risks appear mostly tilted to the upside,” the Bank of Canada’s Mr. Beaudry warned. You may want to keep that in mind.