Why Did the CBO Lower Its Forecast For Long Run Interest Rates?

The Congressional budget office lowered its projection of long run interest rates from 3% in 2013 to 2.5% in its current forecast.  The lower rate is also below to average interest rate of 3.1% between 1990 and 2007.   Interest rates have an important effect on the long term US budget outlook since the national debt is expected to rise and interest payments will demand an increasing share of federal spending.  The CBO forecast improves the long run budget outlook in the US.  Lower interest rates also increase the value of financial assets.

The CBO looked at factors that might increase interest rates along with factors that might lower them in making its forecast.  It is interesting to consider their analysis of the factors that drive interest rates:

Factors That Lead To Higher Interest Rates

• Government borrowing demand increases along with its debt burden.  This crowds out funds available for private investment and makes investment more expensive
• As developing countries become richer they will consume more and send less of their savings to the US

• Higher returns on capital will increase the demand for capital in the private economy

Factors That Cause Interest Rates To Fall

• The demand for safe assets like US bonds has increased due to the financial crisis
• Lower growth in total factor productivity will reduce investment demand 
• Rising income inequality increases the savings rate because wealthy individuals save a greater share of their income

The CBO forecast implies that the factors driving interest rates lower are more powerful than those that would increase interest rates.