Interest rates in the United States and around the world have been declining for decades.
More specifically, “real” interest rates have been declining in what can only be described as a perfect downtrend.
Real interest rates are simply the level of interest rates minus the level of inflation. So if the Federal Funds Rate is 5% and core inflation is 2%, the real interest rate is 3%.
In this post, we’ll look at the main reasons why real interest rates are on this clear downtrend and why the trend will likely continue.
The Trend
As the Federal Reserve has increased interest rates and as inflation has declined, the real interest rate has increased from -6% to 0%.
To combat inflation, some argue that real interest must rise to 4% or 5% or something closer to the levels that were achieved in the 1980s, but this argument does not account for why real interest rates have been declining.
Initial Conditions
The two major factors that have continued to lower the level of real interest rates the economy can handle before tipping into recession are demographics and debt.
Sometimes, debt and demographics are called “initial conditions.”
The reason the economy tipped into recession in 2008 after a real interest rate of just 3% compared to a real interest rate of 5% ahead of the 1990 recession is because of the changes in these initial conditions.
Demographics, in this case, refers to the level of population growth in the prime-age cohort, people aged 25-64.
In the 1960s, 70s, and early 1980s, the period when real interest rates were generally trending higher, the prime-age population growth was rising, increasing from 0.5% in the 1960s to more than 2% in the early 80s.
Why is the growth rate of this prime-age population so important?
The level of consumer spending follows a very predictable pattern as you age. As you move through your 30s, 40s, and 50s, you consume more on average. This adds a positive effect on the economy.
Once you enter your late 60s, your spending starts to decline, and this drags on overall consumption, weakening the growth rate of the overall economy.
Even more important is the pattern of spending for housing and cars, what I call the “cyclical engine of economic growth.”
While total spending peaks in the 45-54-year-old bracket, the high-powered spending on housing and cars peaks in the 35-44-year-old bracket.
So as the growth rate of the prime-age population declines, there is less natural demand for housing and vehicles, and this means there is less need for production, construction, and overall employment in the sectors that build, transport, and service these critically important areas of the economy.
Now, I said natural demand for a reason. When the prime-age population starts to decline, and the economy feels the negative effect of this natural progression, there is a large incentive to artificially boost the consumption of these high-powered goods because it is very beneficial for the overall economy.
The way to artificially boost the demand for these sectors is generally by lowering interest rates and making it easier to borrow money, which brings up the problem of debt.
In the 1960s, 70s, and early 1980s, the total level of debt in the US economy was about 150% of GDP. As interest rates have been pushed lower, artificially stimulating the demand for these high-powered goods, the country has accumulated debt to the tune of 360% of GDP.
Of course, the accumulation of this debt occurred for more than one reason, but as debt levels rise, the only way you can support a higher debt load is with lower interest rates.
So there is a very tight correlation between declining demographics and the artificial stimulation of the cyclical economy through increased debt. The problem is then the economy cannot support higher interest rates, which is why we’ve seen a very persistent downtrend.
Before we can make a direct comparison to the 1980s, we have to understand the differences in initial conditions.
Changes Vs. 1970s & 1980s
Over the next 10-15 years, it’s projected that the prime-age population will only grow about 0.2% on average compared to 0.7% in the 2010s decade.
Due to ballooning entitlement programs, increasing levels of student debt, and consumer credit card debt, we know with near certainty that debt levels over the next ten years will be higher than the last ten years.
The slightly worse demographics will put downward pressure on the demand for housing and vehicles (over time), and this will make the economy weak unless real interest rates continue on this downtrend. In that case, the economy may have brief periods of strength but will slip into recession at lower and lower levels of real interest rates. This situation is a major problem because the economy has already found itself with the start of a banking crisis, credit contraction, and a pending recession at a real interest rate of just 0.0%.
So this trend will continue, and real interest rates will continue to grind lower over time until the economy clears its debt burden because the demographic picture is more or less set in stone.
An economy needs, at the very least, a positive level of real interest rates to function properly, so this trend is not your friend. Lower real interest rates tend to disadvantage the moderate and low-income part of the population.
The US Is Still Better Than ROW
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