Fed officials, of course, are well aware of this issue6 and choose to believe that the declining trend will continue rather than reverse. Certainly some of the drop in the participation rate can be attributed to shifting workforce demographics, and it may be unrealistic to project a return to 66%. Nonetheless, it seems peculiar to disregard the fact that the participation rate held steady at 66%—only a percentage point below its all-time peak—from 2003 through 2008, and started falling only in response to the 2009 recession. Surely a combination of long-term demographic trends and cyclical pressures must be at work.
Perhaps Fed officials are right to continue to revise their goals for the unemployment rate. They justifiably claim to be data-dependent, but the data they emphasize, the official unemployment rate and personal consumption expenditures, simply don’t tell the full story anymore. Additionally, Janet Yellen recently seems to be paying more attention to real wage growth. (We have had none at all.) Wage growth merely in line with inflation may not be sufficient to push rates significantly higher.
So how fast will interest rates rise, and how high will they go? Given these intractable imbalances in the labor market, the answer is likely “slowly and not as high as many think.”
In our reading of the March FOMC statement, the Fed was preaching caution and confessing a willingness to err on the side of lower rates. A key line in the statement says: “The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.” Lower for longer indeed.
But what rate is “normal in the longer run”? The equilibrium real interest rate is perhaps the most crucial rate for long-term investors in any financial market. Note, however, that this rate is unobservable, and estimates invariably provoke strong disagreement. Charles Plosser and Janet Yellen, both brilliant economists with deep insight into this question, would give very different answers. What drives this long-term equilibrium rate? Importantly, it is not set by the Fed. The Fed merely tries to keep prevailing rates roughly in line with this ideal, and it manages short-term rates to smooth out business cycle fluctuations. Economic conditions, not Janet Yellen, set the long term equilibrium rate.
Macroeconomic theory gives us some guidance. At Research Affiliates, we model the equilibrium real rate as a function of two key variables: country-specific real GDP growth and a time preference factor that favors current consumption over future consumption. If these factors represent the supply side and demand side, respectively, for an intertemporal transfer of wealth, then the equilibrium rate of interest is the price at which supply will equal demand.
A growing economy offers many investment opportunities for those who are willing to delay consumption. This high natural demand for investment may cause interest rates to rise in order to attract an increased supply of investment funds. On the other hand, lifecycle events drive natural preferences for saving and spending. An increase in the desire to save will result in a greater supply of investment funds, and exert downward pressure on interest rates.
Our models use demographic variables to proxy the long-term supply of savings, and forecasted real GDP growth to estimate the demand for funds represented by investment opportunities.7 Demography tells us that, as the baby boomers age and shift their focus toward retirement, their emphasis on saving grows; this exerts downward pressure on real interest rates. At the same time, slow economic growth provides a relative dearth of investment projects. These projects, as a result, need only offer a modest return to attract investment capital.
Both factors imply a continuation of low real rates for an extended period of time. Our 10-year forecast (Figure 3) is for real interest rates to rise from a current −1.38% to just about zero in 2024.8 Because this baseline rate reverberates throughout the economy, expected real returns on bonds of all maturities and risk characteristics, and even equities, should also remain low.