Demographics and the Behavior of Interest Rates

Abstract

Interest rates are very persistent. Modelling the persistent component of interest rates has important consequences for forecasting. Factor models of the term structure are restricted VAR models that project over a long-horizon the one-period risk free rate to obtain yields at longer horizon as the sum of the expected future monetary policy and the term premia. The included factors are typically mean reverting and the equilibrium real rates are considered constant (think, for example, of the standard Taylor-rule), partial adjustments to equilibrium yields are then used to rationalize the persistence in observed data. As a result the empirical models feature a very high level of persistence that makes long-horizon predictions inherently inaccurate. This paper relates the common persistent component of the U.S. term structure of interest rates to the age composition of population. The composition of age structure determines the equilibrium rate in the monetary policy rule and therefore the persistent component in one-period yields. Fluctuations in demographics are then transmitted to the whole term structure via the expected policy rate components. We build an a¢ ne term structure model (ATSM) which exploits demographic information to capture the dynamics of yields and produce useful forecasts of bond yields and excess returns that provides economic value for long-term investors.

Some Evidence on Secular Drivers of US Safe Real Rates

“…26 of these have expected sign, and most though not all are significant. In terms of support for demographic variables as correlates of real rates, these results fall roughly midway between the regression results of Poterba (2001) on the one hand, who finds modest support for demographic variables, and Geanakoplos et al (2004) and Favero et al (2016) on the other, who find exceptionally strong support. Table 3 and line (5c) of Table 4 reflect long periods when the two moved in opposite directions: the mid-1900's-mid 1920 's, 1930-1970, and the mid-1980's-2016. Note that the trend value of this correlate moves quite slowly.…”

" A New Normal for Interest Rates? Evidence from Inflation-Indexed Debt"

“…In particular, although our measure of the real rate fluctuated a bit at the start of the Financial Crisis, our average r real-side fundamentals such as changing demographics (e.g., Carvalho et al 2016, Favero et al 2016, and Gagnon et al 2016.…”

On secular stagnation and low interest rates: Demography matters

“…The authors show that population ageing leads to subdued output growth, higher savings and lower interest rates; an increase in the fraction of the dependent population and a decline in the share of the working‐age population lead to a statistically significant decline in real interest rates. Favero, Gozkulu, and Yan () show that the common persistent component of the term structure of interest rates is related to the ratio of middle‐aged to young population. Favero and Galasso () show that interest rates are depressed by the increased savings of the middle‐aged population in response to longer life expectancy.…”

“…We complement the analysis by Aksoy et al () and Favero et al () by focusing on the euro area and providing an assessment of the macroeconomic impact of ageing after the global financial crisis. Differently from Aksoy et al () and Favero et al (), we focus on dependency ratios rather than on the age composition of the population. We share with Aksoy et al () the assumption that demographic developments are exogenous.…”