By Michael Saunders, Senior Policy Advisor at Oxford Economics

Over the last year, neutral rates have risen significantly in the US, Eurozone and UK. Historically, neutral rates have been extremely and consistently low, particularly in pre-pandemic times. Yet, various drivers including rising inflation expectations and inflation volatility have caused an unprecedented growth.

A shift in neutral rates

Before deep diving into the drivers and implications of neutral rates, though, it’s important to firstly understand their meaning and their shift over time. Neutral rates are, at a basic level, the rates at which monetary policy is neither accomadative nor restrictive for economic growth. The rate changes overtime in conjunction with various supply shocks and structural factors. However, from the 1980s up to the start of the pandemic, the rate remained constantly low.

Banks expected this low level to continue, yet in over the course of the last two years, rates dramatically shifted upward. Market pricing for UK short-term rates rose from 1-1.25% in 2021 to 4% today, compared to the average of 2-2.5% from 2015-2019. It is anticipated that this growth will continue into 2023 and the following years ahead.

The effect of this on economic structures will be somewhat destabilising: higher neutral rates will result in new policy rates and extreme pressures on public finances. Central banks will feel this pressure most prominently and will likely struggle to stabilise real output. If the anticipated aggressive global trends and negative supply shocks of 2023 prevail, it seems neutral rates will continue their upward trajectory, giving way to an uncertain economic future.

Underlying drivers

Numerous factors determine the neutral rate. The pre-pandemic decline, spanning multiple decades, can be explained by abrupt demographic changes, slower productivity growth, global capital flows and a decline in long-term inflation expectations. Some of these factors have continued over recent years. Economic productivity growth, for example, has averaged 0.5% from 2020 to now. These persistent conditions can be systematically ruled out when questioning the complex cause of increase in rates. Although the increase could be down to a correction of excessively low levels of forward rates in 2020-2021 or a shift to quantitative tightening, it is most probable that the underlying driver is rising inflation expectations.

High inflation expectations are evident across numerous advanced economies. Data has revealed increasing household inflation expectations in the US, UK and Eurozone. Higher wage growth than unemployment and elevated service inflation is also apparent. The current soaring levels of inflation caused people to assume that rates will continue increasing, even if headline inflation falls. These expectations are not unfounded; we saw the same pattern in the 1970s and 80s. Consequently, with higher inflation assumptions, higher levels of nominal policy rates are needed to achieve inflation targets.

Inflation has also become more volatile in recent times which may explain the rising neutral rates. From 2000-2019, UK inflation volatility was at a record low of almost 2%. Globalisation, the end of Cold War and growth of democracies stimulated a political consensus in favour of openness, interaction and trade, resulting in increased supply chains and reduced inflation. High volatile inflation was considered a thing of the past. Yet, this has changed sharply in current times due to damaging supply shocks such as Russia’s war in Ukraine. Although it will be difficult to predict the upcoming shocks in 2023, it can be expected that aggressive global trends like authoritarianism, localisation of trade and reduced globalisation will contribute to an upward bias of inflation.

The future outlook and impact of neutral rates

It is expected that neutral nominal rates in 2023 will remain elevated versus pre-pandemic norms, prompting cyclical swings in central bank policy. However, there are some potential risks that may result in neutral rates declining. If the headline inflation rate falls and unemployment rises, we may see a decline in household inflation expectation and pay. Similarly, globalisation may revitalise and impart a downward impetus to inflation, in turn reducing neutral rates. Despite this, it can be assumed that if there are further adverse supply shocks, inflation expectations will remain up, leading to growth in market-implied interest and neutral rates.

In terms of impact, higher levels of nominal interest will prove adverse for public finances as increases in debt service costs would outweigh likely gains from higher tax receipts on interest income. This would be a less favourable environment for investment and evoke challenges for central banks. As a result, banks might struggle to judge what level of policy rates will be enough to return inflation to target and place more emphasis on traditional business cycle indicators. It will be hard to calibrate policy precisely within this tightening. Central banks will also be more likely to develop a need to act through monetary policy to ensure expectations are achieved, making it hard to stabilise real output. As a consequence, financial institutions might be more reluctant to pivot to monetary easing.

Essentially the rise in neutral rates is a notable and critical shift for the global economy. It is fair to assume these rates will continue considering the aforementioned underlying factors that are widespread and deep rooted. The challenge therefore turns to banks and how they will manage policy within a new climate of growing rates.