The Lombard Review
Economy

The new normal for interest rates is higher

Fiscal and demographic drivers lift r*

The U.S. Treasury Building, Washington
The U.S. Treasury Building, WashingtonPhoto: MeanieHyaena / Wikimedia Commons, CC BY 4.0
1 min read Data: Dec SEP longer-run dot 2.5%

The Federal Reserve’s Summary of Economic Projections has quietly begun an analytical retreat from the era of secular stagnation. For years, the committee anchored its longer-run median policy rate projection at 2.5 per cent, implying a real neutral rate (r*) of a mere 0.5 per cent. That structural anchor is now coming unglued under the weight of fiscal reality.

The north face of the Eccles Building, Washington
The north face of the Eccles Building, WashingtonPhoto: AgnosticPreachersKid / Wikimedia Commons, CC BY-SA 3.0

The Structural Elevation of r*

Structural demographic shifts, persistent multi-trillion-dollar federal deficits, and the enormous capital requirements of artificial intelligence and decarbonization capex are permanently raising the clearing cost of capital. A neutral policy rate of 2.5 per cent is an anachronism in an economy operating with structural fiscal expansion. The Fed will be forced to steadily revise its long-run rate assumptions higher.

The U.S. Capitol at night
The U.S. Capitol at nightPhoto: Diliff / Wikimedia Commons, Public domain

The steady drift higher in the Fed's estimated neutral rate confirms that the era of ultra-cheap money was a historical anomaly rather than a permanent economic fixture.