Swedroe: Longer Lives Lower Interest Rates

November 30, 2015

Ever since the global financial crisis, the real interest rates of developed economies have remained in negative territory. Nominal interest rates hover near zero, and inflation rates, although quite low for historical standards, have remained positive (in most countries, at least on average). What’s more, negative nominal interest rates have even been observed in some developed countries for the first time.

The typical explanation for these low real rates is the extremely loose monetary policies (qualitatively, through lowering interest rates, and quantitatively, through bond-buying programs) put into place in response to the crisis. In the past several years, many of Wall Street’s gurus have persistently warned that the low-rate environment will soon be over and central banks will begin the tightening cycle.

A Study Of Demographics And Interest Rates

Carlos Carvalho, Andrea Ferrero and Fernanda Nechio—authors of the September 2015 paper, “Demographics and Real Interest Rates: Inspecting the Mechanism”—have a different perspective.

The authors begin by noting that real interest rates have been trending down for more than two decades across many countries, suggesting that there are forces other than accommodative monetary policies at play. Their hypothesis is that demographic trends offer at least a partial explanation for low and declining real interest rates.

They note the world is undergoing a dramatic demographic transition, and write: “In most advanced economies people tend to live longer. In Japan, the U.S. and Western Europe, life expectancy at birth has increased by about 10 years between 1960 and 2010, and new generations have continued to expect longevity to increase. At the same time, immigration notwithstanding, population growth rates are decreasing at a fast pace, and in some cases (e.g. Japan) becoming negative. The combination of the population growth slowdown and the increase in longevity implies a notable increase in the dependency ratio—i.e., the ratio between people 65 years and older and people 15 to 64 years old.”

According to the authors, consequences of this demographic transition are far-reaching and result in important macroeconomic, public finance and political economic repercussions. They develop a life-cycle model that captures important features of this demographic transition in developed economies, and then predict the real interest rate. Following is a summary of their findings:

  • The overall effect of a prototypical demographic transition is to lower the equilibrium interest rate by a significant amount.
  • In response to the demographic transition, the equilibrium real rate declines by 1.5 percentage points, to 2.5%, in the study’s “representative developed country” between 1990 and 2014.
  • The model explains about one-third of the overall decline observed in the data since 1990.
  • The increase in the probability of a person surviving longer, rather than the fall in the population growth rate, is mainly responsible for the decline in the real interest rate explained by the demographic transition.
  • The model predicts that real interest rate will fall an additional 50 basis points over the next 40 years before stabilizing around its new steady-state value of 2%.
  • The demographic transition, and in particular the higher probability of surviving, does not carry large consequences for macroeconomic aggregates. Rather, the real interest rate bears the bulk of the adjustment. In the aggregate, consumption falls by about half a percentage point.

Impact Of Falling Population Growth Rate

The authors show that another notable aspect of the demographic transition is the fall in population growth rate. However, they found that the repercussions this has on the real interest rate are quantitatively less significant than the increase in life expectancy.

The reason is that “a falling population growth rate brings about two effects working in opposite directions. On the one hand, a lower population growth rate reduces the pool of workers, thus increasing the capital-labor ratio. Therefore, the rental rate decreases, and, by no arbitrage, so does the real rate. On the other hand, however, a lower population growth rate progressively increases the dependency ratio—the ratio of retirees to workers. Because retirees have a larger marginal propensity to consume, this effect tends to offset the consequence of the less efficient use of capital. Overall, the effect is negative, but quantitatively small.”

Suggestive Anecdotal Evidence

In their study, Carvalho, Ferrero and Nechio presented country-pair comparisons in order to provide some anecdotal evidence for these relationships within the data. The key result from the model is that the demographic transition—and, in particular, the increase in life expectancy—drives the decline in the real interest rate observed during the last 2 1/2 decades.

To perform their analysis, they considered data for two base years: 1990 and 2005. They then calculated “five-year averages, centered at 1990 and 2005, of the short-term real interest rate and life expectancy … . For example, in 1990, Thailand and Singapore had similar projected change in life expectancy, but differed in their short term rates and life expectancy. Singapore had higher life expectancy and lower short-term yields. Similar patterns hold for other country-pairs, such as Egypt-Tunisia in 2005, and India-Indonesia in the same year. All three pairs of countries featured similar projected changes in life expectancy, and the country with higher life expectancy also had lower short-term real interest rates.”

Importantly, and not unexpectedly, the authors noted that they found exceptions, illustrating the challenge in determining empirically the overall impact of demographics on real interest rates.

Policy Implications

Carvalho, Ferrero and Nechio also consider the policy implications of lower real rates. They note: “In a world where the average equilibrium real interest rate is 2%, a 2% inflation target implies an average nominal interest rate of 4%. If, however, the equilibrium real interest rate falls to zero, perhaps due a combination of demographic trends and other forces, the resulting average nominal interest rate now becomes 2%. All of a sudden, the room for central banks to respond to recessionary shocks has shrunk considerably …. If the central bank fails to adjust the nominal interest rate to the low frequency movements in the efficient real interest rate induced by demographics, monetary policy is systematically too tight, and deflation arises in equilibrium.” They further observe that their model can explain the persistence of Japanese deflation since the early 1990s.

In addition, the authors consider how an increase in retirement age would impact real rates. They found “an increase of two years in the retirement age—a typical reform currently being implemented in advanced economies—leads to a rather modest rise (10 basis points) in the real interest rate.”


The demographic transition that all advanced economies are currently experiencing is a factor in helping to explain the prolonged decline of global real interest rates. The main channel through which changing demographics affect the real interest rate is the increase in life expectancy. This is because, at all stages of their life cycle, individuals save more to finance consumption over this longer time horizon. Quantitatively, the demographic transition can account for about one-third of the overall decline in the real interest rate since 1990.

These findings have important implications for investors planning for their retirement. First, we should not expect real rates to return to their long-term averages. Second, lower-than-historical real interest rates mean either that investors will have to accumulate a larger pool of assets to meet their financial goals or that they will have to accept more equity risk to make up for lower real returns on bonds. And third, people who already are in retirement—which is usually accompanied by a high bond allocation—should also account for now lower expected returns.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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