Why interest rates will likely stay elevated

3 minutes 51 seconds

Inflation is high, and the pound in your pocket is buying less. Interest rates are set to rise further, but the question is: how far should they go? The high inflation and interest rates of the last two years may seem unusual, but we have been here before.

Prices began to rise, and people had to pay more for food and clothing. High inflation followed by high interest rates has happened several times. I remember being in the back of my parents’ station wagon in the mid-1970s. My mom waited in line for a long time, and it turned out we were waiting in the gas lines because fuel was being rationed. I was a child and did not know what inflation was, but I knew we had to wait a long time and that my parents struggled during that period.

Since the 2008 global financial crisis and through the COVID-19 pandemic, low interest rates drove equity valuations to unsustainable highs and bond yields to unfathomable lows. A low-interest-rate environment is another way of saying that long-term expected future returns are likely to be low because investors do not benefit from the compounding power that higher interest rates can provide as a tailwind for portfolios.

Supply and demand disruptions, particularly in goods and labor markets, sparked generationally high inflation as economies recovered from pandemic shocks. To fight that inflation, developed-market central banks have been raising short-term interest rates. The inflation fight is not over, but we are confident it will be won. As inflation falls to central bank targets, we expect cyclical interest rates to moderate from recent peaks, though not to the lows we recently became accustomed to.

We have not only been here before; we have been in this type of environment more often than not over the past three centuries of market history. History will likely show that the past 10 years were the exception, not the norm.

Vanguard believes that structural interest rates will stay elevated for years to come. We estimate that neutral rates are higher than they have been recently. The neutral rate is a theoretical equilibrium policy rate that would neither stimulate nor restrict an economy. By our estimate, the real neutral rate, which is adjusted for inflation, has settled roughly one percentage point higher than it was in the years after the global financial crisis.

A higher-rate environment has far-reaching implications for the economy and markets. Emphatically, bonds are back. Fixed income portfolios have a high probability of outperforming the rate of inflation over the next decade.

The implications for equities are more mixed. Longer term, as with any investment, higher interest rates can be positive because investors can compound at higher expected returns. The caveat is that when interest rates are higher, stock markets can look more expensive today than they otherwise would. In other words, there may be no pain without gain.

Higher interest rates may be bad news for borrowers, but they are good news for savers and diversified investors. This marks the return of sound money. Sound money exists when interest rates are above the rate of inflation. That has been the historical average, though it has not been the case for the past 15 years. The return to sound money is arguably the single best financial market development over the past two decades.