How structural demographics, capital demand, and fiscal deficits are permanently increasing the natural rate of interest
For the better part of a decade since the 2008 global financial crisis, macroeconomic theory and monetary policy has operated on the premise that the natural or neutral rate of interest, denoted (r), has experienced a permanent, structural decline. With globalization-driven excess savings, aging populations, low productivity trends, and capital-intensity of new technology, the underlying equilibrium interest rate (r) that clears the economy without inflation or disinflation was forecasted to remain close to zero or negative. Central banks in advanced economies were forced to implement quantitative easing and yield curve control, as they were trapped at the zero lower bound (ZLB).
The era of low - (r*) macroeconomic policy is ending. The new post-pandemic macroeconomic environment, featuring structural supply disruptions, large capital expenditures, green energy requirements, and historic peacetime fiscal deficits, has driven a permanent increase in the equilibrium interest rate. Central banks and financial markets are now operating in an environment where the neutral rate of interest is higher than it was prior to 2020. In this note, we examine the structural forces driving up the neutral rate of interest and the fiscal dominance risk that monetary policymakers currently face.
The Structural Drivers Behind Higher Equilibrium (r*)
The neutral interest rate (r*) is an unobservable theoretical concept that describes the interest rate at which savings and investment in the economy are equal at full employment and stable prices. The nominal policy interest rate can be decomposed as:
i = r* + 𝝅e + 𝝓
Where (i) is the target nominal interest rate, 𝝅e is expected inflation, and 𝝓 is the term premium or risk-free rate. Four structural trends in the economy have combined to push the neutral rate of interest higher in the past 5 years:
First, the global savings glut has unwound into an investment supercycle. The combination of reshoring supply chains, building out the infrastructure for artificial intelligence and cloud computing, and the capital expenditures associated with the green energy transition have all put upwards pressure on the global demand for loanable funds. Unlike the software-driven digital economy, these structural transformations require trillions of dollars of new capital expenditures, and are therefore capital-scarce activities from a macroeconomic perspective.
Second, demographic trends in the developed world are reducing the global pool of available savings. As the baby boomer generation ages and enters retirement across North America, Europe, and East Asia, these large swaths of the population shift from being net-savers to net-consumers. As a result, the overall global pool of savings is contracting, and
real interest rates are being pushed higher as a result. Third, the trend towards deglobalization and regionalization of production chains has reduced the cost advantage of the international division of labor. While this structural shift reduces the risk of global supply chain disruptions, it comes at the cost of higher average costs for goods and services, compared to a regime of unrestricted international trade. As a result, central banks need to adopt higher interest rates to balance aggregate demand and supply at full employment.
Structural Pre-2020 Economic 2026 Economic Regime Impact on Equilibrium Factor Regime r∗
Capital Low physical capital High physical capital Upward Pressure: Demand deployment; dominance of deployment (AI datacenters, Increased demand for
asset-light software utility grid scaling, energy loanable funds raises models. transition). real rates.
Demographic Peak labor force age Mass retirement of major Upward Pressure: Saving groups generating an demographics leading to net Shrinking supply of
excess global savings glut. asset decumulation. global savings elevates borrowing costs.
Fiscal Deficits Moderate post-crisis fiscal Structural, multi-trillion-dollar Upward Pressure:
consolidation efforts; annual deficits across major Massive sovereign debt austerity policies. advanced economies. issuance crowds out private capital.
Global Trade Hyper-globalization Friend-shoring, nearshoring, Upward Pressure:
optimizing for and trade fragmentation Elevated baseline cost-efficiency and optimizing for resilience. supply costs require localized concentration. tighter real policy.
The Fiscal Dominance Channel
The second major force that is permanently raising interest rates is fiscal dominance, a condition in which fiscal policy crowds out monetary policy.
Government debt/GDP ratios have exploded in advanced economies as a result of pandemic-era fiscal support, subsidies for industrial policy, increased defense spending, and higher entitlement spending. The US federal budget deficit remains at 6-7% of GDP even as unemployment reaches record lows. These unsustainable fiscal policies directly drive up interest rates, as central banks attempt to balance inflation at the new higher level of public debt.
Higher interest rates required to maintain price stability in the face of fiscal expansion have unintended consequences for sovereign budgets. Interest payments on public debt constitute one of the fastest-growing areas of public expenditure, dwarfing defense spending and contributing to the overall fiscal deficit.
When a central bank enters a period of interest rate hikes, the burden of public debt increases substantially for government budgets. If the government is required to spend more on interest payments, it may need to raise additional revenues through taxation or new bond issuance. This results in an increase in the supply of government bonds and drives up yields on long-dated paper, as investors require a higher risk-free rate of return. If the private bond market refuses to finance additional paper at the elevated interest rate, the central bank faces a dilemma of either allowing sovereign yields to spike (adversely affecting the fiscal position of the state) or monetizing the debt and potentially losing control of inflation.
Macro-Financial Implications of a Higher r*
The new macroeconomic environment featuring higher interest rates requires a reassessment of financial and economic activity:
- Hurdle Rates: A low interest rate environment encouraged the valuation of long-duration projects with distant cash flows that were discounted at near-zero rates. Firms needed to show a credible path of future cash generation and were able to achieve valuations based on high forward-looking projections. In a high-$r^$ environment, discount rates applied to future cash flows result in lower valuations, requiring firms to demonstrate near-term cash generation and higher return on capital.
- The Refinancing Wall: As firms take on long-duration, low-cost debt to finance operations and growth, they are faced with a large maturity wall of debt that needs to be refinanced at significantly higher interest rates. This adversely impacts the profitability of firms, particularly those that are highly-leveraged, and exacerbates the widening performance gap between strong and weak firms.
- Private Equity Valuation Compression: Private market investments, such as in private equity and commercial real estate, are also facing valuation compression. Higher risk-free rates reduce the availability of cheap leverage, forcing private equity funds to generate higher returns through operational performance and margin expansion rather than financial leverage.
Outlook
Structural forces have pushed the natural rate of interest higher, and central banks may need to keep interest rates higher for longer rather than return to the low-interest rate regime that was the norm prior to 2008. As sovereign debt expands and capital expenditures increase, higher interest rates will become the new normal.
Sources & Citations
- "Measuring the Natural Rate of Interest (𝑟*)," Federal Reserve Bank of New York (June 2026).
- "Fiscal Dominance and the Monetary Policy Transmission Mechanism," Bank for International Settlements (BIS) Working Papers (No. 1182, May 2026).
- "The Structural Reallocation of Global Capital," IMF Economic Review (Vol. 74, Issue 2, July 2026).
- "Sovereign Debt Burden and Term Premium Dynamics," Journal of Monetary Economics (August 2026).