How high can US rates go in the Trump era?

After eight years in which interest rates in rich countries have kept close to all-time lows, a change of weather is in the air.

Donald Trump’s election as US president and widespread expectations that the Federal Reserve will nudge rates higher this week have made their mark on the markets.

The big question is whether short-term pressures for higher US interest rates are strong enough to overturn long-term global forces that push borrowing costs ever lower — such as an older population, rising inequality and falling productivity growth.

Financial markets still expect the Federal Reserve to raise rates slower than its own projections. But an increasing number of economists argues that circumstances have changed so much that not just the markets but even Fed policymakers are now underestimating the potential for interest rates to rise next year.

The two-year US Treasury bond yield rose on Monday to its highest level since 2010 at 1.15 per cent. Some analysts declare that, after a three-decade long slide, interest rates have now reversed course. Ian Shepherdson, chief economist at Pantheon Macroeconomics, says the Fed will find it harder to downplay low unemployment and rising wage growth after Congress has passed some of the fiscal stimulus favoured by Mr Trump.

“We are worried that inflationary pressure, which is already building in the labour market, will become a serious problem, forcing the Fed to raise rates quite rapidly,” he says.

But despite the broad consensus that Mr Trump’s stimulus plans will lead to higher interest rates — a prospect the president-elect welcomes — many economists and market participants think the additional stimulus will not be sufficient to alter the outlook significantly.

Some, such as Larry Summers, Treasury secretary under Bill Clinton, argue that Mr Trump’s tax cuts are skewed to the rich and will “do little if anything to spur growth.

While the size of the fiscal stimulus package is still shrouded in mystery, the Organisation for Economic Cooperation and Development has estimated that it will raise US growth 0.4 percentage points to the still modest level of 2.3 per cent in 2017. Because underlying conditions have deteriorated, that rate is only 0.1 percentage points higher than the OECD’s US growth forecast in June.

The OECD expects 2018 growth of 3 per cent, boosted by 0.8 percentage points from fiscal stimulus — but that falls short of the ambitions of Steven Mnuchin, Mr Trump’s pick for Treasury secretary, who has talked about 3 to 4 per cent growth becoming normal again.

Meanwhile central bankers stress that interest rates are still likely to settle at much lower levels than in the past. They say low rates stem from an increase in the global desire to save, which forces down rates to discourage excessive saving, so that there is enough spending to keep unemployment down and inflation stable.

Mark Carney, governor of the Bank of England, talks about an “unprecedented desire for safety”.

Economists have put forward various explanations for the underlying fall in interest rates. An ageing population tends to lead to a higher desire to save for a longer life. Greater inequality has concentrated more income into the hands of groups that save more and spend less. High levels of debt also require interest rates to stay low since borrowers — including governments, companies and consumers — are often unable to withstand higher interest rates.

Perhaps the most worrying trend has been a fall in the annual growth rate of productivity in all regions of the world. According to Stanley Fischer, vice-chairman of the Fed, “weak productivity growth has likely pushed down interest rates both by lowering investment . . . and by increasing saving”. In both instances, lower productivity growth leads to lower expectations of future income, leading both companies and consumers to save rather than spend.,

Mr Trump’s fiscal stimulus may indeed lead to productivity gains. But most economists see the relationship between growth and productivity as the other way around, with productivity gains ushering in greater growth rather than vice versa.

“These kind of measures would probably not be sufficient to strengthen US trend growth by resolving low productivity and the decline in the working population,” says George Magnus, an independent economist.

He argues that, since the likely stimulus would come at a time of close to full employment, short term interest rates may rise faster than expected. But long term natural interest rates are a different matter — a Fed rate rise this week may be an important step in its own right, but not necessarily a break with the past.