Federal Reserve: Declining attractiveness of government bonds drives key interest rates higher

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Researchers at the New York Fed say a key global interest rate is rising, and the main reason appears to be a decline in the appeal of government bonds in terms of safety and liquidity.

The so-called “natural interest rate”—that is, the short-term rate when the economy is at full employment and inflation is stable—has seen a “statistically significant increase” since 2019. According to a blog post by New York Fed researchers, the natural rate in the U.S. and other developed economies has risen by about 1 percentage point.

The researchers noted that although there are other factors driving interest rates higher, a weakening of investor interest in government bonds as safe assets may account for as much as half of the increase in the natural rate. This can be seen in the narrowing spread of U.S. corporate bond yields. This change has various reasons, possibly including the surge in government debt in developed economies.

Although the natural rate is just a theoretical concept (often referred to as r-star in economic analysis), it matters because it affects central banks' decision-making when setting market interest rates. Fed Chair Powell described the natural rate at the annual central bank conference in Jackson Hole, Wyoming in 2018 as a key guiding star relied upon by sailors navigating the seas.

The New York Fed article pointed out that, after statistical analysis, the natural rate in the U.S. and its global counterparts have shown a significant increase in the post-pandemic era. In the previous period (1990 to 2019), “investor preference for safety (and liquidity) drove the yields on government bonds in developed economies steadily lower,” which in turn brought down the neutral interest rate as well.

The researchers also said that other possible factors driving up the interest rate in the post-pandemic era include: productivity growth prospects driven by artificial intelligence. In addition, economies undergoing demographic shifts may see a rising debt-to-GDP ratio, and expectations of higher military spending may also be among the causes for the rise in the natural rate, or both factors together.

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