US Treasury yields are climbing, partly on expectations that R-star — the economy's neutral interest rate — may be structurally higher than in the past. Heavy government borrowing and surging investment in artificial intelligence are lifting demand for capital, a combination that could keep interest rates elevated for longer than markets have anticipated.

A structurally higher R-star carries broad implications. It could limit how far the Federal Reserve is able to cut its policy rate, put downward pressure on Treasury prices as yields rise, and increase borrowing costs across the wider economy, from mortgages to corporate debt.

Estimating the elusive neutral rate

R-star, often written as r*, is the theoretical short-term interest rate at which monetary policy is neither stimulating nor restraining the economy. It cannot be observed directly and must be estimated, which is why the concept is often described as elusive. Central banks, including the Federal Reserve, monitor estimates of the neutral rate to judge whether their policy stance is restrictive or accommodative. If the economy's true neutral rate has shifted upward, then a policy rate that once seemed restrictive may in fact be closer to neutral than assumed.

Estimates of R-star generally fell in the years after the 2008 financial crisis, when low growth, low inflation, and high savings by households and businesses kept the neutral rate historically low, a shift often linked to the era of near-zero policy rates and bond-buying programs. A reversal of that shift would mark a meaningful change in the environment facing both central bankers and investors, since much of the past decade's market pricing was built around the assumption of a persistently low neutral rate.

Yield curve faces upward pressure

Expectations of a higher neutral rate add to upward pressure on the Treasury yield curve. Yields are also being supported by heavy issuance of government debt, as sustained federal borrowing increases the supply of Treasuries that investors must absorb. For investors, the question to watch is how the market's long-run rate expectations evolve: yields on long-dated Treasuries and the Fed's own published projections of the longer-run policy rate are among the benchmarks used to gauge whether a repricing of the neutral rate is underway.

AI boom fuels demand for capital

The artificial intelligence boom is a significant driver of capital demand. Building AI infrastructure — data centers, computing capacity, and related energy and networking assets — requires large-scale, long-duration investment. The scale of this spending is contributing to economy-wide demand for financing, working alongside government borrowing to keep pressure on interest rates.

Productivity could provide another boost

Productivity growth could provide another boost to the neutral rate. AI-driven efficiency gains, if realized across the economy, tend to raise the economy's potential growth rate, which is one of the factors that influences the level of R-star. This would echo the late 1990s, when strong productivity growth associated with the信息技术 diffusion is widely cited by economists as a period when a higher potential growth rate supported a higher neutral rate.

Source: Economic Times Markets