On My Mind: The Twin Roots of Rising Rates

Two driving forces are now simultaneously pushing in the direction of higher long-term real interest rates. While investors and commentators often tend to conflate the two, I think it is useful instead to distinguish them clearly. They are rising investment, and persistently large fiscal deficits.

A new trend toward stronger investment has emerged and is likely to endure for the next several years, driven by a number of important priorities: (a) there is a need to make up for past under-investment in infrastructure, including traditional infrastructure as well as digital infrastructure. The American Society of Civil Engineers’ latest report assigns a failing grade to overall US infrastructure (not for the first time)1; (b) rising geopolitical tensions necessitate an increase in defense spending across Western countries; © growing interest in the potential of Artificial Intelligence calls for new investment in the necessary hardware (notably semiconductors), software and energy; (d) the green energy transition requires more investment to boost the role of renewables; and (e) manufacturing companies need to continue to invest in new technologies, which includes making supply chains more resilient.

Not all of this will result in rapid gains in productivity. For example, while the green energy transition is a very important goal, a lot of the required investment will not increase productivity growth in the short and medium run. Because it consists of replacing existing capital, it increases current economic growth via higher expenditures, but it does not raise productivity—much like rebuilding existing structures after they’ve been destroyed by a hurricane. The economist Jean Pisani-Ferry, in a recent report for the French government, has estimated that in fact investment in the green transition will likely reduce productivity growth by a quarter percentage point per year for the next several years. (The report also warns that the green transition increases inflation risks over the next decade)2.

However, the bulk of investment should over time result in faster productivity growth (the acceleration in US productivity during 2023 already gives hope, even if the weak first quarter of this year counsels caution). Faster productivity growth should in turn drive faster real economic growth, reversing one of the key arguments of the Secular Stagnation theory3, and implying a higher equilibrium interest rate in the long run.