The global shift away from centralized manufacturing (deglobalization) requires redundant investment in infrastructure like semiconductor fabs in multiple countries. Simultaneously, the AI revolution demands enormous capital for data centers and chips. This dual surge in investment demand is a powerful structural force pushing the neutral rate of interest higher.
Because the neutral rate of interest (R-star) is a theoretical, unobservable concept, policymakers can manipulate its estimated value to justify their desired interest rate policies. This allows them to argue for rate cuts or hikes based on a non-falsifiable premise, making it a convenient political tool rather than a purely objective economic guide.
A single neutral interest rate may not exist. There could be one R-star for the investment-heavy AI sector and another for housing. A separate R-star might even be needed for financial stability. This divergence means the Fed faces a policy trade-off where a rate that balances one part of the economy could destabilize another.
Fed Governor Stephen Myron argues Trump's policies will lower the neutral rate, necessitating aggressive rate cuts. Conversely, Bloomberg Economics’ model suggests these same policies—like massive government borrowing and fracturing trade alliances that reduce foreign capital inflows—will significantly increase the neutral rate, highlighting the concept's deep ambiguity in practice.
A simple framework explains the structural shift to higher interest rates. Retiring Boomers spend savings (Demographics), governments borrow more (Debt), global capital flows fracture (Deglobalization), AI requires huge investment (Data Centers), and geopolitical tensions increase military spending (Defense). These factors collectively increase borrowing costs.
Despite nominal interest rates at zero for years, the 2010s economy saw stubbornly high unemployment and below-target inflation. This suggests monetary policy was restrictive relative to the era's very low "neutral rate" (R-star). The low R-star meant even zero percent rates were not stimulative enough, challenging the narrative of an "easy money" decade.
For decades, a tacit global agreement existed: the U.S. buys the world's goods and provides security, and in return, the world finances U.S. debt by buying Treasuries. As U.S. policy shifts towards protectionism and reduced global policing, other nations may no longer feel obligated to fund U.S. deficits, pushing borrowing costs higher.