Declining population growth and rising dependency ratios in the developed world have been one key factor behind the decline in nominal and real interest rates since the 1980s. Personal savings for retirement are growing, while investment spending is not rising commensurately, and long-term economic growth is dampened by slowing or even shrinking work forces. A new ECB paper suggests that for the euro area these trends will likely continue to compress interest rates for another 10 years, a challenge for monetary policy and financial stability.

Ferrero, Giuseppe, Marco Gross, Stefano Neri (2017),” On secular stagnation and low interest rates: demography matters”, No 2088 / July 2017.

The post ties in with SRSV’s summary briefing on non-conventional monetary policy and SRSV’s summary briefing on macro trends.

The below are excerpts from the paper. Emphasis and cursive text have been added.

The great secular decline in interest rates

The decline of long- and short-term nominal interest rates started in the mid-1980s as part of a global phenomenon and coincided with a decline of real interest rates, a strong and persistent reduction of inflation and a period of low macroeconomic volatility, the so-called ‘Great Moderation’.”

“The decline accelerated with the outbreak of the global financial crisis. Since late 2008-early 2009, the slack in the economy and protracted low inflation rates contributed to further reducing nominal interest rates, as monetary policies turned very accommodative.”

“Real interest rates have [also] been decreasing since the second half of the 1980s. This trend, too, has accelerated with the outbreak of the global financial crisis, and in the euro area after the sovereign debt crisis. According to some recent analyses, a similar trend has characterized the evolution of the natural interest rate, which is defined as the real short-term interest rate that keeps output at its potential, unemployment at its natural rate and inflation at the central bank’s target.”

On the compression of the natural rate of interest in the U.S. view previous post here.

“The decline in short- and long-term interest rates brought about a decline in the financing costs of banks, non-financial corporations, households and governments, which reached historical minima.”

Why demographics matter

“Low interest rates [are attributed to] structural and cyclical [causes]…

  • According to the structural view, advanced economies suffer from a persistent imbalance resulting from an increasing propensity to save and a decreasing propensity to invest; in this context, excessive savings act as a drag on growth and inflation, exerting a downward pressure on real interest rates.
  • According to the financial cycle viewperiods characterized by deregulation in the financial sector, excessively expansionary monetary policies and overly optimistic expectations of future returns contribute to…excessive debt at low interest rates…As credit increases, asset prices are pushed up, raising their value as collateral, relaxing borrowing constraints and inducing a further increase in credit and asset prices…When financial shocks hit the economy, both the supply and demand of funds decrease…The central bank significantly eases monetary conditions…An extensive need for deleveraging and a high degree of uncertainty…further reducing real interest rates.”

“Demographic trends [are part of the structural explanation. They] affect both the demand and the supply side of the economy. Lower fertility and longer longevity, which lead to a higher old-age dependency ratio, require more savings for old age, unless these are offset by an increase in the retirement age, and may cause a decline in aggregate consumption as a share of income. Population trends also affect investment demand, as lower population growth implies that lower investment is required to maintain a given capital-to-labor ratio, reducing real interest rates. An increasing proportion of elderly people leads to a shrinking working-age population; given the capital stock, this lowers the real rate due to the higher capital intensity.”

On the increasing propensity of an aging population to save also view previous post here.

Over the last 45 years there has been considerable increase in dependency ratios – the amount of people at non-working age (0 to 14 and above 65) compared to the number of those at working age (15 to 64) – a key statistic for measuring the degree of aging of a society. Population growth has also declined in most economies, although with varying patterns. Lower population growth implies that the elderly cohorts increase in size relative to the younger ones. Declining fertility rates, which have fallen sharply after the introduction of the contraceptive pill in developed countries in the early sixties, and increased life expectancy have contributed to the aging of the population… The sharp and persistent decline in fertility rates can be seen as the end point of a global demographic transition that started with the decline in child mortality which led to exceptionally large young age cohorts and an unprecedented growth in population…Other factors equal, these demographic trends have led to an increased supply of savings, as workers have to save more to finance their consumption during the retirement period.”

Findings for the euro area

“The objective of this paper is to provide new evidence related to the impact of demographics on real interest rates and other macroeconomic variables in the euro area, adopting both a backward- and forward-looking perspective.”

“The empirical analysis is based on a dynamic panel vector autoregressive model with 11 endogenous and 2 exogenous variables, containing a sample of 19 euro-area countries and spanning the period from 1990 to 2015. The endogenous model variables are potential output growth, real GDP growth, total factor productivity growth, investment growth, private consumption growth, GDP deflator inflation, investment deflator inflation, private consumption deflator inflation, changes in unemployment rates and real short-term and long-term interest rates. The two exogenous variables are population growth and the (change in the) total dependency ratio…

  • The estimates…suggest that an increase in dependency ratios, which results from the aging of the population, and a decrease in population growth have a clear potential to push nominal and real interest rates downward…The real short-term interest rate depends negatively on population growth and the change in the dependency ratio, whereas the real long-term rate depends negatively only on population growth.
  • Results confirm that the aging of the population [reduces]…long-run potential output growth: a smaller share of the younger cohorts may imply lower innovation and investment in R&D, which would reduce potential growth in the long-run…Real GDP, potential output, investment and consumption growth depend negatively on the change in the dependency ratio… negatively affected by the change in the dependency ratio.”

Predictions for the euro area

“The demographic structure in many European countries has developed adversely according to various indicators already over the past one to two decades, and the adverse trends are expected to turn even more adversely over the coming decade…The worrisome expected evolution of the demographic structure in Europe requires assessing the impact of demographic developments on real interest rates and potential output growth.”

“Building on the European Commission projections for dependency ratios until 2025…the foreseen structural change in terms of age structure of the population may dampen economic growth and continue exerting downward pressure on real interest rates also in the future…The aging implied in this scenario is the result of slowing dynamics of fertility, rising life expectancy and specific assumptions in terms of migration. The proportion of young people (aged 0-14) is projected to remain relatively constant over the next decades in the euro area (around 15%), while those aged 15-64 are expected to constitute a substantially smaller share, declining from 66% to 57%. Those aged 65 and older are expected to constitute a much larger share (29% of the population, from 19%).”


“Understanding why interest rates have fallen is essential for both monetary policy and financial stability. To the extent that nominal and real interest rates are low in normal times, monetary policy may be constrained by the presence of the effective lower bound (ELB) of policy rates, potentially limiting the ability of the central bank to preserve price stability in the aftermath of a recessionary shock.”

“Low nominal and real interest rates may also pose risks to financial stability, reducing financial institutions’ profitability and resilience, raising the likelihood of bubbles and potentially leading to excessive risk-taking by investors.”