What happened to the lower-for-longer interest rate narrative? It has been sidelined over the past two years as central banks hiked interest rates to rein in surging inflation. But now that we’re seeing a pause in rate hikes, what can investors anticipate in the long run? Or taking it a step further, is there such thing as an "optimal" interest rate?  

The R-star

To provide some insight and to help answer this question, TD Asset Management Inc. (TDAM) recently published an article titled Finding Guidance with the R-star’s Light that discusses the concept of the R-star and how it can guide views for long-term interest rate expectations.

The R-star is the level of interest rate when an economy is at full strength and inflation is stable in the long run (the optimal rate). The concept traces its origins back to the early 20^th century so it's not a new concept. But the R-star gained in prominence by the U.S. Federal Reserve (the Fed) in the early 2000s and has since become a widely used data point for interest rate expectations. 

The trend

Over the last 20 years the modeled optimal rate of interest has been declining, but the formula isn’t that cut and dry either. The absolute level of optimal rate isn’t hugely important as that number fluctuates through time. For example, a real policy rate of 3.5% in 1999 can be expansionary, while a real policy rate of 1% in 2015 can be contractionary which may seem counter intuitive. The reason this occurs is simple: the R-star is independent of a central bank’s direct control; instead, it is driven by long-term economic factors like productivity and demographics and medium-term financial drivers like capital flows.

Over the last two decades, the R-star in the U.S. and Canada has been declining as productivity growth has shrunk and the population has aged materially. The decline in productivity growth can be attributed to the fact that technology has been widely adopted and the scope for rapid gains has diminished when compared to the internet boom and the post-World-War-II era.

At the end of 2023, as central banks are seeking to quash inflationary pressures, the real Fed funds rate is at around 1.8% versus an R-star of about 1.3%. This can be defined as a contractionary monetary policy environment.

The outlook

We at TD Asset Management Inc. feel that the R-star in Canada and the U.S. will remain unchanged and stay between 0 and 2%, which is where it has been for the last 20 years. This is assuming that demographic trends are unlikely to reverse their course as the population will continue to age for decades to come. However, there is one caveat. Because the demographic transition is already well entrenched, the demand for safe assets will continue to increase, but the pace of the increase will moderate and the downward impact on the R-star will be less pronounced.

Predicting the future is always tricky. But for investors seeking direction on where long-term interest rates will go, considering the R-star concept can be helpful, especially since short-term fluctuations don’t impact the long-term outlook for the optimal interest rate.

_{The information contained herein is for information purposes only. The information has been drawn from sources believed to be reliable. Graphs and charts are used for illustrative purposes only and do not reflect future values or future performance of any investment. The information does not provide financial, legal, tax or investment advice. Particular investment, tax or trading strategies should be evaluated relative to each individual's objectives and risk tolerance.}

_{This material is not an offer to any person in any jurisdiction where unlawful or unauthorized. These materials have not been reviewed by and are not registered with any securities or other regulatory authority in jurisdictions where we operate.}

_{Any general discussion or opinions contained within these materials regarding securities or market conditions represent our view or the view of the source cited. Unless otherwise indicated, such view is as of the date noted and is subject to change. Information about the portfolio holdings, asset allocation or diversification is historical and is subject to change.}

_{This document may contain forward-looking statements (“FLS”). FLS reflect current expectations and projections about future events and/or outcomes based on data currently available. Such expectations and projections may be incorrect in the future as events which were not anticipated or considered in their formulation may occur and lead to results that differ materially from those expressed or implied. FLS are not guarantees of future performance and reliance on FLS should be avoided.}

_{TD Global Investment Solutions represents TD Asset Management Inc. ("TDAM") and Epoch Investment Partners, Inc. ("TD Epoch"). TDAM and TD Epoch are affiliates and wholly-owned subsidiaries of The Toronto-Dominion Bank.}

_{® The TD logo and other TD trademarks are the property of The Toronto-Dominion Bank or its subsidiaries.}