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European Interest Rates: How Far to R*?

04 December 2024
3 min read
A telescope stands out from a purple star-spangled sky.
| European Economist—Fixed Income

When the ECB’s rate-cutting cycle ends, should the neutral rate be far higher than pre-pandemic? Not in our view.

With central banks worldwide now advancing through their easing cycles, investors are mulling where interest rates will ultimately settle. The right answer hinges on a key variable: the “neutral rate,” known in academic studies as R*. This is essentially the long-term equilibrium rate required to keep growth and inflation in balance over time.

Because monetary policy works with a long and variable lag, policymakers can’t observe R* in real time. Instead—in the face of challenges and uncertainties—they have to estimate it. Their central problem: determining whether neutral rates will converge back to pre-pandemic levels, or whether the recent inflationary breakout has pushed R* higher in some or all economies.

The solution? We think the European Central Bank (ECB) should concentrate on the underlying structural issues driving euro-area economies, stripping out recent forceful but transitory cyclical factors triggered in large part by the COVID pandemic and the energy shock.

Is R* Rising to a New Level?

Before the pandemic, academic models were clear that R* was trending downwards. Some of those same models, however, now suggest that R* may once again be rising.

Studies Suggest R* May Be Rising, but Model Findings Diverge
Two out of three pictured model results suggest that R* is rising – and the third suggests that R* is falling sharply!

Current and historical analyses do not guarantee future results.
As of  March 4, 2024
Source: Semi-structural models combine some of the flexibility of time-series modelling with the theoretical rigor of structural models. Surveys shown above: (1) Holston-Laubach-Williams (2023) and (2) Hordahl-Tristani (2014). Survey-based models assess perceptions of the natural rate, using expectations based on the ECB's Survey of Monetary Analysts (SMA) in the euro area. Survey model shown above: Benigno, Hofmann, Barrau and Sandri (2014), BIS Quarterly Review.

Which model is the most informative? There’s a reliable guideline, in our view.

We believe it’s important to distinguish between the structural factors that are known to drive R* over the long term and temporary cyclical factors. For instance, a recent ECB study highlights the significant impact on R* of several cyclical factors including: the pandemic itself; the resulting supply-chain disruptions; the energy shock following the invasion of Ukraine; and governments’ stimulus packages.

While these factors contributed to the recent rise in the neutral rate, they’ve already reversed or are in the course of doing so, and are therefore unlikely to exert further upward pressure, in our view. Meanwhile, we don’t think anything has changed structurally in the eurozone to justify a significantly higher neutral rate than the pre-pandemic level.

Risks to R* Are on the Downside

We see the eurozone returning to pre-pandemic economic conditions—at best.

Real euro-area GDP growth is expected to remain similar to its pre-pandemic level, so output will continue to fall short of potential for the foreseeable future. In fact, we estimate the eurozone’s growth potential will likely fall from 1.2% to below 1% by 2028.

Euro-Area Potential Growth Rate Is Trending Lower
Drivers of Potential Growth (Percent)
In a bar chart (2002-2028E) the shrinking bar for labor (rather than capital or productivity) drives potential growth lower.

Current and historical analyses do not guarantee future results.
As of November 15, 2024
Source: European Commission

Adverse demographics are a big part of the eurozone’s growth problems: an aging population is constraining the labor supply. While net migration partly offsets the workforce decline, the positive impact for Europe is lower than in the US, and the overall euro-area trend is still down.

Dwindling Labor Supply Drains Potential Growth
The working age euro-area population is shown falling by 12% from 2024 to 2069E - a far bigger % drop than total population.

Current and historical analyses do not guarantee future results.
As of June 18, 2024
Source: Eurostat

As in the US, expansionary fiscal policy in Europe has likely pushed the euro-area R* higher in recent years. But looking forward, we think European countries will have less scope for large-scale spending programs, and the positive impact on R* will fall away.

The market is currently pricing the ECB’s policy rate to settle at between 1.8% and 1.9%—a reasonable proxy for the market estimate of the neutral rate. That's within the range of pre-pandemic estimates but, in our view, too close to the upper bound and with room to move lower.

With euro-area potential growth likely to continue slowing, fiscal policy remaining stable and inflation falling, we think both R* and the end-point of the ECB’s easing cycle will be lower than the market currently forecasts (Display).

The Market Expects Euro-Area R* to Rebound
R* Estimates (Percent)
The market is pricing R* at around 2.2% for 2027 compared with AB’s forecast of 1.75% and a pre-pandemic neutral rate of 2%.

Current and historical analyses do not guarantee future results.
As of November 29, 2024
Source: Bloomberg and AB

The views expressed herein do not constitute research, investment advice or trade recommendations, and do not necessarily represent the views of all AB portfolio-management teams and are subject to change over time.

About the Authors

Sandra Rhouma is a Vice President and European economist on the Fixed Income team. Previously, she was a global economist and strategist at Millennium Global Investments, a London-based currency investment manager. From 2019 to 2022, Rhouma worked for the European Central Bank as a banking supervision analyst before moving into a US economist position. She holds a PhD in economics from the University of Surrey and a master’s degree from Paris 1 Panthéon-Sorbonne. Location: London