Does demographics explain decline in US natural interest rate?

Before 2008 crisis, there was thinking that US natural rate of interest is hovering around 2.5%. Natural rate is the rate at which economy grows without creating inflation.

As crisis struck in 2008, the Fed brought rates close to zero and as economy recovered, the idea was to push the interest rates to its natural level. But then there was a change in thinking that may be natural rates themselves have declined to below 1%. This leads to the thinking that may be Fed has tightened the rates a bit too much and needs to bring them down towards natural rates.

This piece by Sungki Hong and Hannah G. Shell in St Louis Fed research suggests demographics have a role in declining natural interest rates:

Demographics can affect the natural rate of interest through several channels. Remember, if potential output declines, the natural rate declines with it. An aging population and slowing population growth limit the supply of available workers in an economy. Therefore, holding labor productivity constant, a decrease in workers—a higher old-age dependency ratio—reduces the output generated by an economy. A smaller working-age population means fewer people with a lot of disposable income to consume. These factors decrease an economy’s productive capacity and thereby lower the natural rate. U.S. labor force participation is up compared with the 1960s, despite a long decline since the mid-1990s.1 By itself, this rising labor force participation would tend to raise the natural rate by increasing productive capacity and, in turn, the natural rate of interest. 

An aging population also impacts the natural rate of interest through the savings rate. A higher savings rate increases the supply of loanable funds that banks can lend out, therefore decreasing interest rates. As life expectancy increases, the time individuals spend in retirement increases as does the amount of money they will need to last through retirement. If working-age individuals believe social safety nets will fail, they are likely to save more to offset the risk.2 The U.S. savings rate did increase somewhat from 2005 to 2008; however, for the most part, U.S. household savings has declined since the 1970s. 

 

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