The Euro Area and World Interest Rates

1
The Euro Area and World Interest Rates

• Menzie D. Chinn
• Univ. of Wisconsin-Madison NBER
• Jeffrey A. Frankel
• Harvard University NBER

Presentation at Elteville, Germany September 13,
2003
2
Motivation

• Revisit the determinants of interest rates
• Investigate the impact of EMU
• Re-examine the role of debt against backdrop of
  new theory empirics

3
The Shift in Fiscal Conditions Budget Surplus
Source OECD Economic Outlook, June 2003
4
The Shift in Fiscal Conditions Net Debt
Source OECD Economic Outlook, June 2003
5
Is There a Debate?

• studies that (properly) incorporate deficit
  expectations in addition to current deficits tend
  to find economically and statistically
  significant connections between anticipated
  deficits and current long-term interest rates.
  (Gale and Orszag, 2003, p. 20)

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Quantitative vs. Qualitative

• The small effect of debt on interest rates
  does show ... that attempts to stimulate the
  economy by raising taxes in order to lower
  interest rates are likely to be unsuccessful...
  The resulting reduction in interest rates will
  probably be too small to outweigh the negative
  effects of tax increases (ERP 2003, p.58)

7
Findings

• Short term rates tightly linked
• Long term rates have country-specific effects
• US rates still matter for European rates
• Debt matters

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Outline

• Short term nominal rate dynamics
• Long term real rate dynamics
• Determinants of long term real rates
• Conclusions and Outlook

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Convergence at the Short Horizon?
Source IFS, June 2003
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Real Rate Convergence?
Source IFS, June 2003 and authors calculations
11
European Convergence
Source IFS, June 2003
12
US and Euro Area Policy Rates
Source IFS, June 2003
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Who Drives Rates?
Source IFS, June 2003
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Testing for Convergence
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Results
Table 1 Nom. Money mkt. rates
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Longer Horizons

• Less linkage expected (liquidity issues,
  political risk)
• Evolution over time (dismantling of capital
  controls)
• Empirical literature

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Convergence in Long Term Rates
Source BIS, July 2003
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US, Germany, France
Source BIS, July 2003, and authors calculations
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US, Italy, Spain
Source BIS, July 2003, and authors calculations
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Estimation
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Results 1973-95
Table 2 Long term real rates
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Results 1996-2003
Table 2 Long term real rates
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Panel Results
Table 3 Long term real rates
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Determinants of Real Interest Rates

• 1988-2002
• Annual data
• Debt, expected debt
• Cyclical factors
• Foreign factors (interest rate, global debt)

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Estimation
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Results
Table 5 Determinants of long term real rates
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Panel Results
Table 6 Determinants of European long term real
rates
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Interpretation

• Debt matters
• Expected debt sometimes matters
• Output gap not consistently important
• US interest rates matter for European countries
• Global debt doesnt enter as expected

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Conclusions

• US interest rates still appear to drive other
  interest rates, but less so
• Idiosyncratic country effects remained important
• Unclear for post-EMU period
• Likely that debt trends will matter in coming
  years

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Implications
Source OECD, BIS and authors calculations