The neutral interest rate – the level at which it neither over-stimulates or stifles the economy – is elusive and unobservable. Known by economist as R*, unlike nominal interest rates, it is shaped behind the scenes by long-term structural factors. 

The concept of the neutral interest rate is a key reference point for the calibration of monetary policy, helping central banks assess whether policy is stimulative or restrictive. It also underpins asset valuation.

Like any interest rate, R* is determined in credit markets by the balance between savings (the supply of credit) and investment (the demand for credit). 

For firms to undertake new investments, they need households and other savers to provide the capital to finance it. Thus, aggregate investment must match available savings. To achieve this, interest rates must be high enough to incentivise savings, while remaining low enough to encourage borrowing. The interest rate that achieves this balance in the long run is R*.

In the US, the Fed currently estimates R* between 0.78% and 1.37% based on two different methodologies. Recent publications from the European Central Bank also suggest the R* estimates span a range of -0.5% to +0.5% through to the end of 2024.

Whichever methodology is used, the direction of travel is clear: R* has declined sharply in advanced economies over the past three decades. However, that may be about to change.

Demographics appear to play a major role in shaping R*. According to the United Nations, by the mid-2030s there will be 265 million individuals aged 80 and older — outnumbering infants — and higher life expectancy tends to increase precautionary savings, placing downward pressure on R*.

The sustainability of pension systems will come under growing pressure as the dependency ratio rises. This could raise government deficits, exerting upward pressure on interest rates. Similarly, age-related reductions in labour supply could elevate wages and inflationary pressures, driving nominal interest rates higher. 

Fiscal deficits have risen sharply in major economies over recent decades. According to the Institute of International Finance (IIF), global debt (public and private) rose by approximately $7.5 trillion to a new record high of over $324 trillion in the first quarter of 2025.

Current international tensions are prompting increased defence and infrastructure spending, often financed through larger deficits. According to the Stockholm International Peace Research Institute, global military expenditure reached $2.7 trillion in 2024. Financing such spending will require higher debt issuance, likely putting upward pressure on interest rates.

Productivity is frequently cited as a key determinant of R*. Higher productivity growth typically boosts R* as it raises expected returns on capital and stimulates investment demand. Conversely, slower productivity growth may contribute to a lower natural rate.

In 2021, the Organisation for Economic Cooperation and Development found that declining productivity across advanced economies has been a primary driver of falling R*. In the euro area, average productivity growth fell from roughly equal to 1.6%  between 1995 and 2005 to approximately 0.6%  from 2010 to 2020, which is consistent with near-zero R* levels.

However, transformative technologies — especially artificial intelligence — could reverse this trend. The International Monetary Fund projects that AI adoption could cumulatively boost total factor productivity (TFP) in Europe by 1% over five years – though stricter regulation could reduce this by a third.

Geopolitical fragmentation may push the world economy towards a less efficient equilibrium with higher costs, inflation and interest rates. Various studies estimate that severe fragmentation could reduce global GDP by between 5% and 7% in the long term — that is up to $7.4 trillion in lost output.

Globalisation has been a powerful deflationary force over the past decades but current shifts, coupled with the rise of nearshoring and friendshoring, may undermine supply chain efficiency. Escalating tariff tensions may further fragment global trade.   

Energy transition towards net-zero emissions will require massive investment. Some estimates suggest that achieving the Paris Agreement on climate change’s targets would necessitate roughly $9.2 trillion in annual spending by 2050 — $3.5 trillion more than today’s annual investment of $5.7 trillion.

Meeting climate targets will likely push R* higher, given the sheer scale of required capital deployment.

While uncertainty remains, the equilibrium rate in the ‘new normal’ will differ from that of the hyper-globalised, ultra-liquid world that followed the 2008 financial crisis. 

Today, we observe the coexistence of structurally higher interest rates with low unemployment, reflecting an environment in which pension systems, public finances, ageing populations and the green transition will require unprecedented levels of investment.

At the same time, the rise of AI could spur productivity gains, lift average returns and, therefore, push rates higher. 

Ultimately, all these challenges share a common feature: they will demand significant financing in the coming decades.