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After nearly two years of steady interest rate hikes in most developed markets, and with inflation falling back from generational highs, we expect central banks’ policy rates to remain near current levels in the first half of 2024 before receding. As inflation falls toward central banks’ targets, monetary policy will become increasingly restrictive in real terms. The resilience that global economies exhibited through much of 2023 is likely to fade as the effects of Covid-era expansive fiscal policy and excess savings diminish.
Inflation’s initial surge was driven by well-understood factors, including pandemic-related supply-demand imbalances, sharply higher commodities prices, and expansionary fiscal policy. As we move into 2024, most of the remaining gap between current levels of inflation and central banks’ targets is attributable to services, a typically “stickier” component of inflation tied closely to labor markets.
We expect policy interest rates to reach or remain at their peaks in the first half of 2024, dampening economic activity. We expect the U.S. and other developed markets to experience below-trend growth in 2024, with uncomfortably high odds of slipping into mild recessions.
This economic slowdown, coupled with inflation falling to target, gives us conviction that central banks will start to ease policy in the second half of 2024. In our base case, we expect rate cuts of 75 basis points in the euro area and 150 to 200 basis points – or 1.5 to 2 percentage points – in the U.S.
Although policy rates are likely to be cut, we expect them to settle at a higher level than we’ve become accustomed to in recent years. By the end of 2025, we expect policy rates to be between 2.25% and 3.75% across major developed markets. We’re not returning to a zero interest rate world anytime soon, and this will have profound implications for the global economy and financial markets.
Although interest rates in 2024 are likely to recede from their peaks, in the years ahead we expect them to settle at a higher level than we experienced after the 2008 global financial crisis. Zero interest rates are yesterday’s news.
In our view, the equilibrium real interest rate – also known as the neutral rate, r-star, or r* – has increased. This is the theoretical level of interest rates at which monetary policy would neither stimulate nor restrict an economy. Described another way, the neutral rate is the balancing point between savings and investments in an economy.
Vanguard research suggests r-star has increased by about 100 basis points – or 1 percentage point – since 2008 to around 1.5% today, making the nominal interest rate around 3.5%.
There are two important drivers for this higher equilibrium rate: aging populations and relatedly higher structural government deficits. As people age and retire, accumulated savings are spent and the size of the working-age population shrinks. On the other side, governments borrow to finance infrastructure and other long-term needs. So, as fewer people are saving and more are borrowing, interest rates will rise.
The pattern exists across other developed markets including the U.K., the euro zone, Australia, Japan, and Canada. Every country has its own dynamics, so the changes occur at different rates, but we calculate an increase of roughly 1 percentage point in equilibrium real interest rates since the GFC.
A notable exception to this upward trend is China, where the economy is rebalancing to a lower, but more sustainable, growth path. In our view, this will lead to a lower equilibrium real interest rate there relative to that of the last two decades.
IMPORTANT: The projections and other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of September 30, 2023. Results from the model may vary with each use and over time. For more information, please see the Notes section.
Joseph H. Davis, PhD, is a Vanguard principal, global chief economist, and global head of The Vanguard Group, Inc.’s Investment Strategy Group, whose research and client-facing team develops asset allocation strategies and conducts research on the capital markets, the global economy, portfolio construction and related investment topics. As Vanguard’s global chief economist, Mr. Davis is also a key member of the senior portfolio management team for Vanguard Fixed Income Group. The Vanguard Global Economics Team contributed to this report. The detailed Vanguard Economic Outlook for 2024 can be viewed on the Vanguard website.
Disclaimer
Content © 2023 by Vanguard Group. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited. This article first appeared on the “Insights” page of the Vanguard Group, Inc.’s website. Used with permission. All investing is subject to risk, including the possible loss of the money you invest. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Diversification does not ensure a profit or protect against a loss.
Investments in bonds are subject to interest rate, credit, and inflation risk.
Investments in stocks and bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. These risks are especially high in emerging markets.
IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.
The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.
The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.
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