In the last few years there have been many economists and pundits arguing that we’ve entered a long era of rising interest rates. Recently James Grant, editor of the Interest Rate Observer, was asked his outlook and gave the following core reasons for his long-term expectation for higher rates.
- Persistently high inflation
- Significant fiscal deficits
- Increasing military spending
We disagree that interest rates will continue higher for an extended period of time.
While we have argued that interest rates, especially Fed Funds Rates, would stay higher for longer than the market was expecting at the beginning of the year, we don’t think the economic landscape supports increasing interest rates for an extended period.
Inflation
Outside of critical supply shocks, like those experienced in the 1970s and during the Covid Lockdowns, inflation generally follows economic and wage growth. Unsurprisingly, interest rates tend to inflation rates albeit with a lag.
So if we can estimate what economic and wage growth might be over the long-term then we can have a better idea of inflation and interest rates.
Economic growth is a function of population growth and productivity growth. It would follow then that wage growth is also dependent upon these factors. So what is the outlook for these?
Population Growth
Population growth rates peaked in 1963 and have since declined below 0.9% globally. In 2023, US population growth was just 0.4%, almost all of which was due to immigration.
Projections are that this rate of growth will continue to decline for the foreseeable future. This means that nearly all future economic growth will need to come from enhancements in productivity.
AI & Productivity Growth
For the last decade, productivity growth rates were pretty weak. That combined with weakening population growth resulted in the depressed economic growth rates that we experienced.
Now we appear to be on the verge of an enormous surge in productivity due to AI. Some studies suggest that large scale deployment of AI could boost productivity growth rates to 3-5% annually.
This would do wonders for the economy but may not actually boost wages. From the Brookings Institute:
The AI revolution is coming, and America needs to embrace what the technology can do for productivity while recognizing its dangers and putting policies in place to ameliorate the negatives. The policy issue we focus on here is that AI may displace workers and push them into lower-paid positions as production shifts away from relying on human labor and more on automation.
It makes sense that highly skilled workers and companies that can leverage AI will reap most of the productivity gains leaving most workers struggling to maintain income levels.
We don’t see how inflation can stay elevated and interest rates long with it if a large portion of workers are experiencing income declines.
Government Spending
Fiscal deficits and increasing military spending both lead to higher government debt levels. While it makes sense that higher debt levels would lead to higher interest rates, this idea discounts the actions of the government to suppress interest rates and reduce their “real” interest rate burden.
As of today the US Federal Debt is $34.7 Trillion. In Q1 of this year, the annual interest expense rate was $1.06 Trillion. That is an effective interest burden of just 3%. If interest rates were to stay elevated or even rise over a longer period, this burden would explode higher.
We expect the government and Federal Reserve to return to a policy of interest rate suppression like they had after the Global Financial Crisis. For the fiscal health of the government, they need slightly elevated inflation and negative real interest rates to gradually work down the economic burden of the national debt.
So while its possible that interest rates might jump over the short-term, we don’t think interest rates can continue at current levels for a prolonged period without serious damage to the economy and the solvency of the Federal Government.
