Interest rate Inflation Climate change multi-globalisation Ageing Public debt

We are on the cusp of a different world, leaving behind 40 years of ever-declining interest rates and inflation. Five defining waves will sweep through the global economy. The first is climate transition, a recent trend. Then there is multi-globalisation and an innovation-driven productivity boom, both of which are shifting trends. The last two waves, ageing and rising debt, are existing trends that will kick into overdrive in the coming decades. In terms of growth, the pros and cons largely cancel each other out, but when it comes to inflation and nominal interest rates, the balance tilts towards higher levels. We are entering a world of structurally higher inflation and interest rates.

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Climate change commodity shocks

Let’s start with the new kid on the block: climate change. The war in Ukraine has spurred investment sharply. Energy independence is suddenly right at the top of the priority list, with renewables as the saving grace. But most estimates assume another doubling of current investments of $2.4 trillion (2.5% of GDP) to meet climate goals.

In assessing the macroeconomic impact, there are the physical impacts of climate change damage, and the transition risks associated with the shift to low-carbon energy sources. In terms of physical damage, there has been a trend increase in insured losses of 5–7% annually since the 1990s (Swiss Re, 2023). In addition, both excessive heat and cold undermine labour productivity and hence growth. Regarding the transition, a major risk during the transition period is that certain technologies and products will become explicitly excluded and worthless. The longer the transition period lasts, the greater the amount of stranded assets – and the greater the economic cost.

The impact of climate change on inflation is not benign. Demand for the resources needed for the energy transition exceeds supply in the short and medium term. The accompanying IMF chart illustrates the scarcity of many commodities at current levels of production relative to projected cumulative demand over the period 2021–2050. A structural shortage of necessary resources increases the volatility of inflation during the transition period and potentially pushes it higher on a sustained basis.

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The same goes for energy prices. In the net zero scenario, the share of fossil fuels shrinks from 80 to 20%. The share of renewable energy increases from 10 to 60%. Some, however, are calling for an immediate end to the use of fossil fuels. We are not ready for that and pushing to that aim will only increase energy volatility. The price spike in oil and gas in late 2021 and early 2022 illustrates the problem.

These temporary price shocks risk being amplified in what the ECB calls a ‘disorderly transition scenario’ (ECB, 2021). A transition shock occurs when governments are forced to suddenly raise the ‘price’ of greenhouse gases (GHGs) sharply, after initially being too slow to respond to climate change. Companies pass on the higher emission costs in their prices. This is accompanied by higher inflation expectations among consumers and an inflation shock of 0.5–2% in the following years.

New technologies could lower inflation. Energy efficiency has offset some of the higher energy costs for companies during the energy crisis of recent years. In the medium and long term, productivity gains from the transition will emerge. Oxford Economics, in its net zero transformation scenario, estimates that global industrial energy consumption will fall by 30% by 2050, while the value added of industrial activity will increase by three-quarters (Oxford Economics, 2023).

The chart shows different supply and-demand shocks and their impact on growth and inflation. The final scenario is a combination of the four. In the short and medium term, we expect an upward impact on inflation and minimal impact on growth. We continue to believe that governments will do what is necessary. In this race, price shocks will come from all sides. In the long term, productivity gains and the net zero cost of energy will depress inflation.

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Debt sustainability with a dose of inflation

The climate transition has another consequence: the rising debt trend will continue, certainly taking into account the other future trends like ageing, increased defence spending and rising populism. The mountain of public debt has never been higher in peacetime. But it is pointless to look only at the size of the debt. Ultimately, it is the portability of debt that creates crises. And this portability has steadily improved over the past 40 years, thanks to a steady decline in interest rates.

Average interest rates paid have recently started to rise again, and this is not going to change any time soon. As we see it, nominal interest rates will rise because of structurally higher inflation. If average nominal interest costs rise above nominal growth, governments will have to run primary budget surpluses to stabilise debt. If not, an interest rate snowball threatens. According to the table below, many countries will see their debt rise rapidly at the actual expected primary deficits, and the challenge increases if / when the implicit interest rates paid on gross debt gradually rise to the actual higher interest rates (see table; last and penultimate column).

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The OECD makes long-term projections for interest rates. For the eurozone, the OECD expects long-term interest rates to be 2.7% by 2030, rising to 3.2% by 2060. For Japan, the UK and the US, they assume 2.5%, 3.1% and 3.3% respectively. Most countries, with the exception of Japan, are slightly above these levels today. Getting inflation under control is somewhat more difficult than expected, even in the short term.

The OECD also forecasts nominal long-term growth rates. Combined with the forecast interest rates, this produces the all-important R-G snowball lever. And the conclusion there is uninspiring: for almost all industrialised countries, long-term interest rates exceed expected growth from 2040 onwards. The difference is limited: between 0.05 percentage points for Belgium and 0.4 to 0.5 percentage points for Spain and Italy. But the hitherto positive leverage is slowly coming to an end.

We have seen different periods of very high debt in industrialised countries in the past as B. Eichengreen et al. (2021) point out in their book. They all got solved one way or the other. So what are the solutions to our debt today? We believe that financial repression, including periods of negative real interest rates, is undoubtedly part of future deleveraging. 3% will be the new 2% inflation target in the medium and long term. However, real interest rates on average are likely to remain a bit higher than in the past decade due to a higher term premium. Central bankers will continue to buy bonds on a regular basis – if necessary – to put additional downward pressure on interest rates. Savings will be needed, as will higher government revenues. But given the many challenges ahead, it will not be possible to achieve budget surpluses this time. This must not be fatal for debt sustainability. Only if governments abandon all fiscal discipline will bond markets push interest rates sharply higher, risking that highly indebted countries get into trouble.

Ageing weighs on real rates but raises inflation

Ageing is another trend that will push debts higher. According to our Ageing Vulnerability index, Anglo-Saxon countries are on average the least vulnerable to the explosion in ageing costs because of the relatively small share of public pensions in total pensions. Japan, the UK and most Scandinavian countries show medium vulnerability. We find high vulnerability in northern and southern European countries. They combine a rapidly ageing population with already high taxes and significant debt.

Ageing vulnerability

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Ageing will hurt Belgium even more

Various studies by the US central bank (E. Gagnon et al., 2016; C. Carvalho et al., 2017) and the Bank of England (N. Lisack et al., 2017) estimate that demographic changes have pushed down real interest rates by 1.25 to 2%-points, mainly due to an increased supply of savings. This downward pressure on interest rates is expected to continue. According to Gertjan Vlieghe, a former member of the Bank of England's rate-setting committee, the substantial savings accumulated by middle-aged and older people more than compensate for the modest decline in savings by pensioners (G. Vlieghe, 2021). ‘The crucial insight is that this demographic transition revolves around the desired asset position [savings stock] of the entire population rather than the savings flow of the elderly,’ says Vlieghe.

A growing segment of the population has a higher desired level of savings to finance their retirement. People in their 50s have much more wealth than they did in their 40s. In the UK, wealth  peaks around the age of 65. Vlieghe shows that the extra savings from the larger middle-aged group exceed the modest disbursements of pensioners. The group aged 60–90 is expected to experience the fastest growth over the coming four decades. If the number of assets per age profile stabilises at current levels, how will the total amount of assets or the average amount of assets per citizen change in the future?

‘The ageing effect has increased the asset ownership per citizen over the past thirty years (see graph). This process is far from over and, to all expectations, will not reverse. In fact we are only two thirds of the way into this demographic transition.’ The impact on the equilibrium interest rate also partly depends on the extent to which people of a certain age anticipate life expectancy to increase and would therefore save even more. Vlieghe concludes: ‘Either there will be more downward pressure on the equilibrium interest rate, or it will simply remain low. There is no upward pressure of a demographic nature, neither in the short term nor the long term.’

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Demographic changes affect the real R*. Inflation becomes relevant when determining the long-term nominal interest rate. Demographic trends may have helped suppress inflation in the last decades. The overall ratio between the number of workers (taking into account labour force participation, unemployment, etc.) and the number of consumers reached its lowest point in the 1970s. Inflation peaked. In the three decades that followed the support ratio increased and pushed prices down. Nevertheless, beginning in 2010 in the US and a few years later globally, the support ratio began to fall again. Inflation is bound to rise again.

This is also the conclusion of a study by the BIS (M. Juselius & E. Takáts, 2018). ‘We find a link between a population’s age structure and inflation, in line with the life-cycle hypothesis,’ the authors say. ‘A larger share of young and old in the population is associated with higher inflation. Conversely, a larger share of working-age people is associated with lower inflation. The finding is statistically significant.’ The age structure and changes therein explain a large part of inflation trends over the long term, both at the national and global level. ‘In the US, for example, it represents a 7 percentage point increase from the 1950s to the mid-1970s, and a similar decline since the 1980s.’

What lies ahead? ‘Based on this historical relationship, it predicts rising inflation over the coming decades.’ Over the past fifty years, the rising share of people of working age has reduced average inflation by three percentage points. Over the next half-century, the rise of the elderly will dominate, resulting in a 3% increase in average inflation.

The conflicting effect on real growth of de-globalisation versus multi-globalisation

The final inflationary trend we studied is de-globalisation. We talk about multi-globalisation because we expect more emerging markets to take their place in the supply chain in the medium term, either as a stopover between China and the West or as a new supply channel. These countries will fully embrace globalisation and the growing trade of goods between them and the industrialised countries will offset the slowing trade between China and the US (and later on Europe?). The second facet of multi-globalisation is the digitalisation of the service industry. This is opening – and has opened – a whole new and fast-growing market of traded digital services.

Globalisation has increased productivity through the diffusion of knowledge and increased competitiveness between countries and firms. There is no doubt that globalisation has depressed inflation and interest rates in recent decades. After accelerating since 1980, merchandise trade as a percentage of GDP is now likely to have peaked. This is partly due to the different composition and price trends of the numerator (goods) versus the denominator (goods and services). The ratio of trade in goods to GDP has been falling lately as GDP, and in particular the prices of services within it, have been rising relatively faster. The ratio has increased since the 1990s due to the commodity super cycle. Until it peaked in 2011  (R. Baldwin, 2022). In addition, the outsourcing of the manufacturing process reached its limit in 2008 and companies want to reduce the complexity of the global value chain.

Although much of the peak is due to falling commodity prices, 'slowbalisation' is happening and will continue. The US, led by Joe Biden, remains hostile to free trade and trade agreements. China is the big bogeyman: it does not play the trade game fairly and threatens the US in its hegemony. In Europe, as well, there is growing resentment about unfair Chinese trade practices. The symbiosis of past decades – technology in exchange for a huge market – is in jeopardy as China enters the European market with its own high-tech products such as electric cars.

Blocking Chinese goods from US or European markets would prompt a response from China, which is dominant in the supply chain of rare metals and critical minerals. Future commodity shocks due to export restrictions are guaranteed. Harmful trade interventions have soared in the past years and will continue to do so. In 2024, the new Corporate Sustainability Reporting Directive will come into force, increasing the pressure on suppliers to meet stricter requirements. Costs for companies are rising, as is inflation as these costs are passed on to their customers and clients.

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If the trend towards de-globalisation intensifies, the IMF  has calculated that technological fragmentation will increase global economic losses to as much as 5% of GDP (D. A. Cerdeiro et al, 2021). Inflation will be pushed higher: in the short run through temporary shortages and adjustment shocks, and in the longer run through structurally higher costs as the most (cost) efficient supply chain is closed. The positive impact of globalisation on inflation disappears in a world with more barriers and regulation.

Productivity: the saving grace ?

Against these four inflationary trends, we see one trend that could partially or fully offset their inflationary impact: productivity and innovation. Increasing productivity is the only source of future growth for ageing Western economies. It is therefore worrying that this source has become increasingly depleted in recent decades. The computer revolution was followed a decade ago by the digital revolution. So far, it has not brought a major acceleration in growth. Consumers may enjoy greater well-being, more tools and apps that make their lives easier and, above all, more enjoyable. But it has not had a concrete impact on our prosperity, on GDP. It has created consumer surplus, but not producer surplus. Only producer surplus is included in GDP.

Why should productivity rise in the coming years, when it has been on a steadily declining path over the past 40 years in Europe and the last 15 years in the US? It has to do with the wider spread of many exponentially fast-evolving technologies. According to technology expert and author Azeem Azhar, exponential technologies improve at a rate of at least 10% per year for several decades at a constant cost (A. Azhar, 2021). Examples of such technologies include artificial intelligence (AI) and ChatGPT, 3D printing, (green) energy, and biology. The unique thing about these technologies is that as their price comes down, they pop up everywhere. And the more widespread they become, the faster productivity growth will be.

Over the past decade, we have seen an acceleration of innovation and dynamism in large technology companies. But raising productivity requires wider diffusion of new technologies, which has not been the case so far. So what are the conditions for productivity to finally pick up? We often get a trend reversal after major shocks such as wars, global financial crises, supply shocks and major political changes, argue Antonin Bergeaud et al. of the Banque de France (A. Bergeaud et al., 2016) . These are often accompanied by major institutional reforms and other trend breaks. Productivity rose sharply from 1939 to 1973, but also after World War I, thanks to the spread of new technologies and a recovery in demand.

We have not been spared shocks in recent years. Companies accelerated the digitisation and automation of their business processes during the Covid pandemic, especially in the service sector and among SMEs. In 2022, the war in Ukraine, primarily in Europe, led to a new supply and energy shock. This has accelerated the energy transition, leading to a tidal wave of productive investments, Reforms are pushed through in exchange for subsidies and cheap loans . But these productivity-enhancing factors are counterbalanced by new green regulations. These gobble up a lot of unproductive adaptation investments and assets that have to be written off early. On top of that, two very important negative factors for productivity are the (temporarily high) cost of energy and deglobalisation. The signs of an increase in productivity are not all pointing in one direction.

However, the prices of exponential technologies are coming down fast in order to be widely deployed. There have been shocks. And there is the rise in US private and government investment in intellectual property (IP, see graph). Investment, especially in IP, has been at the root of accelerating productivity in the past. In the US, spending on IP grew by around 8% a year between 1980 and 2000 but slowed since then and stopped since the global financial crisis of 2007–2008. US productivity followed with a lag of about 7 years. In recent years, overall investment in IP has picked up. If the past is a guide to the future, productivity will follow.

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On top of that, research by the investment bank Goldman Sachs shows that productivity always returns to its long-term mean (Goldman Sachs, 2021). Over the past 140 years, US total-factor productivity (TFP) appears to be stable, with alternating cycles of acceleration and deceleration around an annual average of 1.2%.

On balance, we conclude that in the short term we expect little change in productivity and its impact on the various parameters. In the long term, we see innovation pushing up productivity significantly. This drives real growth and real interest rates and weighs on inflation. The effect on nominal interest rates is neutral. Increased productivity can also, probably partly, offset the upward effect of the other four inflationary effects mentioned. However, taking all 5 trends into account, we expect an upward impact on inflation and nominal interest rates in the short and long term.


Koendeleus 1
05 BFWD 2024 6 Philippe Gijsels

Koen De Leus

Chief Economist BNP Paribas Fortis

Philippe Gijsels

Chief Strategy Officer, BNP Paribas Fortis