Demographics and interest rates

How do ageing populations impact the macroeconomy, specifically the interest rates? 

It's well-known that populations in their prime working years save the most, only to draw this down when they age. In simple terms, young and old consume more than they save, thereby forcing down the aggregate pool of savings available, and thereby force up the interest rates. Sample this canonical illustration. So ageing demographics should be associated with higher interest rates. 

The economist Charles Goodhart, with Manoj Pradhan, has been a staunch advocate of the argument that  ageing populations will boost inflation and thereby interest rate argument. They feel that the labour force will shrink, aging populations will spend more (especially on healthcare) than they'll save, and protectionism and reshoring will reduce the disinflationary effects of global market places. This is also the basis for the old dependency ratio argument - there will be more effective consumers than effective producers. The result will be higher wages, increase in prices, and reduced pool of savings. The combined effect will be higher inflation and interest rates.

Goodhart writes about two trends that will influence the future trajectory of interest rates, pushing them upwards,

First, most of the world is now at the point where the support ratio, defined as the ratio of producers to effective consumers shifts sharply from being beneficial to being adverse. Second, we will observe a slower rate of growth in the number of workers globally. Both of these changes will have profound and, in our view, negative effects on economic growth globally. A worsening of the support ratio will lead to lower savings, as the old consume more and will make up a higher share of the overall population. Similarly, the slower growth in the number of workers must slow down the absolute growth rate... The almost inevitable conclusion is that real rates of interest will reverse from their present decline, and go back up. The current negative real rate of interest is not the new normal; it is an extreme artefact of a series of trends, several of which are coming to an end. Where might real interest rates reach? By 2025 they should have returned to the historical equilibrium value of around 2½–3%, with nominal rates therefore at 4½–5%, perhaps somewhat higher by 2050.

If this were indeed the case, then Japanese interest rates should have gone up. Instead, the country, which is at the frontier of ageing, has been stuck in a low interest rates trap for nearly three decades now. What gives? What do others say? What does research on demographics and interest rates, and interest rates in general inform us?

There are at several important threads. 

1. As countries have developed, the average disposable incomes of their populations have increased sharply. Even with the rising health care costs, a large share of their savings are passed on to the next generation. The widening inequality (more on that later) too exacerbates this effect.

2. Then there are the effects due to longer lives and lower fertility rates. Ronald Lee and Andrew Mason write in IMF's magazine,

In the United States and most other countries, the elderly are net savers and hold more assets than younger adults. Longer lives and lower fertility raise saving rates, reinforcing private saving.

3. Globalisation and financial liberalisation means that what happens in one country becomes dependent on what's happening elsewhere. So, even if one country is ageing and running down its aggregate savings pool, in a globally integrated financial market, it has access to capital from elsewhere. 

4. An ageing society needs less investment. Therefore the downward impact on the pool of aggregate savings due to ageing is offset by the upward effect on it due to reduced demand for investment. Lee and Mason write,

Firms may choose to cut investment in the domestic economy substantially, even as interest rates fall, if they think output and consumption growth will slow in response to a declining population and labor force, and perhaps lower total factor productivity (the portion of economic growth not explained by increases in capital and labor inputs and that reflects such underlying factors as technology). Should firms become pessimistic, even if central banks drive interest rates below zero, the economy could remain stagnant, with high unemployment for many years—a condition some call secular stagnation.

Research by Adrien Auclert, Hannes Malmberg, Frederic Martenet, and Matthew Rognlie support this point by arguing that the demographics has driven down long-run real interest rates. Ageing reduces economic growth, which in turn lowers investment by even more. They write,

Combining population forecasts with household survey data from 25 countries, we measure the compositional effect of aging until the end of the 21st century: how a changing age distribution affects wealth-to-GDP, holding the age profiles of assets and labor income fixed... This effect is positive, large and heterogeneous across countries... In a baseline overlapping generations model this statistic, in conjunction with cross-sectional information and two standard macro parameters, pins down general equilibrium outcomes. Since the compositional effect is positive, large, and heterogeneous across countries, our model predicts that population aging will increase wealth-to-GDP ratios, lower asset returns, and widen global imbalances through the twenty-first century... According to our model, this will lead to capital deepening everywhere, falling real interest rates, and rising net foreign asset positions in India and China financed by declining asset positions in the United States.

They find that the compositional effect leads to an increase in wealth-to-GDP ratio by 312 percentage points for India

This effect will be greater in the more likely low-fertility scenarios. 

5. Then there is the dynamics of widening inequality and its impact on interest rates. Amir Sufi et al have shown that rising inequality weighs on interest rates even more than ageing demographics. Robin Harding points to the mechanism -"rich households have a higher savings rate, so when they get a bigger share of total income, overall savings go up". And more saving relative to investment pushes interest rates down. They write,

Downward pressure on the natural rate of interest (r ∗ ) is often attributed to an increase in saving. This study uses microeconomic data from the SCF+ to explore the relative importance of demographic shifts versus rising income inequality on the evolution of saving behavior in the United States from 1950 to 2019. The evidence suggests that rising income inequality is the more important factor explaining the decline in r ∗ . Saving rates are significantly higher for high income households within a given birth cohort relative to middle and low income households in the same birth cohort, and there has been a large rise in income shares for high income households since the 1980s. The result has been a large rise in saving by high income earners since the 1980s, which is the exact same time period during which r ∗ has fallen. Differences in saving rates across the working age distribution are smaller, and there has not been a consistent monotonic shift in income toward any given age group. Both findings challenge the view that demographic shifts due to the aging of the baby boom generation explain the decline in r ∗ ...

The top 10% income households within a given birth cohort have a saving rate that is between 10 and 20 percentage points higher than the bottom 90%. The large difference is present over the entire sample period, and it becomes even larger over time. Furthermore, there was a large shift in the share of income going to the top 10% of the withinbirth cohort income distribution from 1983 to 2019. By the end of the sample period, the top 10% of the within-birth cohort income distribution had an income share that was almost 15 percentage points higher than the top 10% prior to the 1980s. The higher saving rate of the top 10% together with the large shift in income to the top 10% combined to generate a significant increase in savings entering the financial system from high income households. Overall, we estimate that between 3 and 3.5 percentage points more of national income were saved by the top 10% from 1995 to 2019 compared to the period prior to the 1980s. This represents 30 to 40% of total private saving in the U.S. economy from 1995 to 2019. The rise in saving by high income households is likely a powerful force putting downward pressure on r ∗.

6. Finally, in general terms, economists led by Larry Summers (also this) have revived Alvin Hansen's Depression era idea of secular stagnation to explain the persistence of low interest rates. In this Bank of England paper, Thomas Smith and Lukasz Rachel have argued that the combination of lower investment demand, globalisation, decrease of labour's bargaining powers, shifts in demographics, widening inequality etc have shifted downwards the investment demand schedule and outwards the savings supply schedule. 

They have also sought to quantify the effects of all these forces on interest rates.

Their summary, 

When combined, lower expectations for trend growth and shifts in desired savings and investment can account for about 400bps of the 450bps decline in the global long-term neutral rate since the 1980s. Moreover, these secular trends look likely to persist. This suggests that the global neutral real rate may settle at or slightly below 1% over the medium- to long-run... In the face of adverse shocks, central banks are likely to run up against the zero lower bound on nominal interest rates more often, requiring the use of unconventional policy instruments such as quantitative easing (QE). However, uncertainties over the transmission of QE and concerns over the size of central bank balance sheets, might limit the use of such tools in the future. For large adverse shocks, fiscal policy may therefore need to bear more of the burden of business-cycle management. Low rates may also fuel search-for-yield behaviour, posing challenges for macro- and micro-prudential policymakers.

On the topic there have since been several papers. Summers and Rachel have this and this. This graphic captures their calculations of the impact of all these forces on long-term interest rates.

See also this by Mathew Klein.

In conclusion, we can broadly say there are two conflicting dynamics at work. On the one hand, the accepted trend of older people consuming more than saving (or more dependents than producers) puts an upward pressure on the cost of capital. But on the other hand, there is the reduced investment demand in ageing societies, the greater relative share of savings due to widening inequality, and the globalised nature of financial markets which expands the pool of savings available. The combined effect of all the three is to put a downward pressure on interest rates. Financial models appear to suggest that the latter easily dominates the former. 

And the empirical evidence from Japan, which has been at the frontier of ageing and has been stuck at the zero lower bound for nearly three decades, suggests that we may be in for a long era of low interest rates.

Update 1 (22.05.2022)

Olivier Blanchard writes about why the long-term interests will continue to stay down.

Update 2 (08.07.2023)

Alan Taylor et al have a new paper that examines the trend of long-run interest rates in 10 developed countries and finds the following

Mapping our estimates of the natural rate into growth and demographic drivers, we find that these two contributing factors can explain most of the decline seen since the 1970s. Going forward, economic and population projections look stable, and forecasts of continued slow growth and further aging in the advanced economies in coming decades would mean that natural rates will remain lower for longer absent any other major shocks.