Artificial General Intelligence & Interest Rates
What happens to interest rates when AGI arrives?
Introduction
One thing that I have been thinking about, without coming to any real conclusions, is what happens to interest rates, given the advent of artificial general intelligence (AGI).1
Before we dive into what interest rates are, it’s important to understand the possible effects of AGI on those rates.2 Consider the following:
Economic Growth & Productivity: If, as is widely expected, AGI automates tasks that currently require human intelligence, then it could dramatically increase productivity and economic growth. This may lead to higher returns on investment, which in turn could increase real rates. There’s another possibility to consider, though: AGI may reduce the costs of goods and services. This would create deflation, which in turn would reduce real rates.
Monetary Policy: Central banks, like the US Federal Reserve, use interest rates to manage economic activity and inflation. Since so much about the effects of AGI on economics is unknowable at present, it could disrupt existing economic models. Central banks may need to reconsider their strategies for using interest rates to achieve policy goals.
Investment Strategies: AGI could change the risk and return profiles of different assets, affecting how investors approach portfolio construction. Understanding how AGI might influence interest rates can help investors make more informed decisions.
Debt Management: If AGI alters the trajectory of inflation and economic growth, this could change the real cost of servicing debt.
Income Distribution: AGI may lead to changes in the labor market, potentially increasing income inequality. Interest rates affect wealth distribution through their impact on savings and investment.
Financial Stability: The ability of AGI to process vast amounts of data and potentially execute financial transactions autonomously could lead to increased volatility or stability in financial markets.
Long-Term Planning: For long-term financial planning, such as retirement or insurance, predictions about the future economic environment, including interest rates, are crucial.
Global Economic Integration: AGI might not impact all regions and sectors uniformly. Interest rates could diverge more significantly between countries, affecting global capital flows and economic balance.
Understanding the possible impact of AGI on interest rates is important because it prepares policymakers, investors, businesses, and consumers for the economic realities of a future with AGI.
Real & Nominal Rates
Interest rates are usually separated into two separate rates, the real and nominal rates. The difference between real and nominal interest rates is the inflation rate. The nominal interest rate is the “face value” rate you commonly see advertised by financial institutions.
The real interest rate, on the other hand, is the nominal rate adjusted for inflation, reflecting the true cost of borrowing and the real yield to the lender. It is calculated by subtracting the inflation rate from the nominal interet rate. The formula3 is:
Real Interest Rate = Nominal Interest Rate - Inflation Rate
This real rate provides a more accurate measure of the purchasing power of the interest payments. If the nominal rate is 5% and inflation is 2%, the real interest rate is effectively 3%.
Regarding the relationship with measures of inflation, nominal interest rates are typically influenced by the expected rate of inflation. Central banks, like the Federal Reserve in the United States, may adjust nominal rates to control inflation to a target level. When inflation is high, central banks may increase nominal rates to cool down the economy; conversely, they may lower them to stimulate spending when inflation is low. Of course, whether these manipulations achieve their desired goals is a different question.
Concrete Examples of Using Real Rates
Real interest rates are used by investors, policymakers, and economists to make informed decisions that take into account the impact of inflation. A concrete example of the use of real rates is in the evaluation of investment returns.
Consider a government bond with a nominal yield of 5%. If the inflation rate is 2%, the real interest rate earned on this bond would be:
Real Interest Rate = Nominal Yield - Inflation Rate
Real Interest Rate = 5% - 2% = 3%
Here’s how different parties might use this real interest rate:
Investors: They look at the real interest rate to determine the real return on their investments. If an investor is deciding between different investment options, they will consider the real rate to understand which investment actually yields a higher return in terms of purchasing power. For example, an investment with a nominal return of 6% when inflation is 4% is less attractive than an investment with a 5% return when inflation is only 1%.
Pension Funds: Pension funds with long-term liabilities use real interest rates to discount their liabilities. The real rate provides a measure of the growth of their assets in real terms and thus their ability to meet future obligations.
Central Banks: They use real interest rates to gauge the stance of monetary policy. If real rates are low, monetary policy is considered accommodative, encouraging spending and investment. If real rates are high, it suggests a tightening of monetary policy.
Economists: They use real interest rates to assess the real cost of borrowing and the incentive to save. Real rates affect consumer and business decisions regarding spending, saving, and investing.
Government Policy: Real rates can influence decisions on government spending and debt issuance. For example, if real interest rates are low, it may be a more opportune time for the government to borrow for infrastructure projects, as the real cost of borrowing is lower.
The real interest rate is critical for anyone making decisions that will be affected by changes in purchasing power over time. It’s a key metric for understanding the economic environment beyond the simple nominal rate figures.
Concrete Examples of Using Nominal Rates
Nominal interest rates are commonly used in everyday financial transactions, as they represent the stated rate of interest that financial institutions charge borrowers or pay savers, without adjustment for inflation. Here’s a concrete example involving a savings account.
Suppose you open a savings account with a bank that offers a nominal interest rate of 2% per year. If you deposit $10,000, the bank will pay you interest based on this nominal rate. After one year, the interest you would earn on your savings account, using the nominal rate, would be calculated as:
Interest = Principal * Nominal Interest Rate
Interest = $10,000 * 2% = $200
Thus, at the end of the year, you would have $10,200 in your savings account.
Here’s how the nominal rate is used across different scenarios:
For Consumers: When taking out loans such as mortgages, auto loans, or personal loans, the nominal interest rate is the percentage that lenders will charge on the principal amount borrowed. This rate does not reflect the erosion of purchasing power due to inflation.
For Banks and Financial Institutions: They offer interest on deposits and charge interest on loans based on nominal rates. This is the rate advertised to customers.
For Monetary Policy: Central banks set a target for the nominal interest rate when implementing monetary policy, which influences economic activity. For instance, the Federal Reserve sets the federal funds rate, which is the nominal rate at which banks lend to each other overnight.
Investment Decisions: Nominal rates are often the starting point for investment analysis. While savvy investors will consider real rates, the nominal rate is the upfront, quoted rate before considering the economic environment.
Budget Planning: When businesses and governments plan their budgets and need to include the cost of borrowing, they often use nominal rates to estimate the interest payments on new debt.
The use of nominal interest rates is widespread because they are the rates that are directly observed in the market. They are easy to understand and apply, which is why they are quoted on loans, savings accounts, and investment products.
Let’s speculate a bit
AGI could have profound effects on real and nominal interest rates. AGI could drive productivity and economic growth significantly, potentially leading to deflationary pressures as goods and services become cheaper to produce. This might result in lower nominal interest rates since inflation would be lower.
Alternatively, if AGI leads to rapid economic growth without accompanying deflationary pressures, we might see higher nominal rates as central banks attempt to manage the growth to prevent the economy from overheating.
AGI’s impact on real interest rates is more nuanced. If nominal rates decrease due to deflation but productivity gains from AGI lead to a booming economy, real interest rates could potentially rise, assuming that the nominal rates don’t fully offset the deflationary effect. In contrast, if nominal rates increase due to anti-inflationary policies but the inflation rate rises even more due to AGI-driven growth, real interest rates could decrease.
The relationship between real and nominal interest rates and inflation is an established part of economic theory. However, the potential impacts of AGI are highly speculative and would depend on a multitude of factors including policy responses, the pace of AGI development, and the broader economic context. This is an obviously unsatisfactory answer to the question of how AGI would affect interest rates, but it’s also the only real answer we have at present. We simply don’t know enough about AGI, or AI more generally, to come up with a better answer.
Some links to explore
As you might have surmised from reading this post, I don’t have any great certainty about how AGI will affect interest rates. The best suggestion I have at present is to read a lot of different people’s view on this question, and try to make sense of the range of possibilities. It is clear that AGI is coming at some point in the next decade or two, which means that an answer to the question of its effects on interest rates will be of vital consequence to many people who are presently living.
What would be the impact of an AI boom on interest rates and inflation?
How will artificial intelligence affect real interest rates?
AGI and the EMH: markets are not expecting aligned or unaligned AI in the next 30 years
How would the advent of artificial general intelligence affect real interest rates?4
As per usual, ChatGPT provided some assistance with the ideas presented here, but the majority of the writing in this piece is mine.
Note that a lot of what I am writing in this post is hedged: “could”, “may,” etc. This is an artifact of simply not knowing how AGI will affect interest rates and the economy.
This is overly simplified, but should suffice for the purposes of this post.
This is a question that I asked Aaron Brown on Quora.