The Euro Area and World Interest Rates

Menzie D. ChinnUniv. of Wisconsin-Madison & NBER

Jeffrey A. FrankelHarvard University & NBER

Presentation at

Elteville, Germany

September 13, 2003

Motivation

• Revisit the determinants of interest rates

• Investigate the impact of EMU

• Re-examine the role of debt against backdrop of new theory & empirics

The Shift in Fiscal Conditions: Budget Surplus

-.06

-.05

-.04

-.03

-.02

-.01

.00

86 88 90 92 94 96 98 00 02 04

OECD FinancialSurplus to GDPRatio

Source: OECD Economic Outlook, June 2003

The Shift in Fiscal Conditions: Net Debt

.36

.38

.40

.42

.44

.46

.48

.50

.52

86 88 90 92 94 96 98 00 02 04

OECD Net Debtto GDP Ratio

Source: OECD Economic Outlook, June 2003

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)

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)

Findings

• Short term rates tightly linked

• Long term rates have country-specific effects

• US rates still matter for European rates

• Debt matters

Outline

• Short term nominal rate dynamics

• Long term real rate dynamics

• Determinants of long term real rates

• Conclusions and Outlook

Convergence at the Short Horizon?

.00

.04

.08

.12

.16

.20

1975 1980 1985 1990 1995 2000

US

Germany

UK

Japan

Source: IFS, June 2003

Real Rate Convergence?

-.25

-.20

-.15

-.10

-.05

.00

.05

.10

1975 1980 1985 1990 1995 2000

US Germany

Japan

UK

Source: IFS, June 2003 and author’s calculations

European Convergence

.00

.05

.10

.15

.20

.25

.30

.35

1975 1980 1985 1990 1995 2000

Germany /France

Italy

Spain

Source: IFS, June 2003

US and Euro Area Policy Rates

.01

.02

.03

.04

.05

.06

.07

1999 2000 2001 2002

Fed Funds rate

Euro systemmarginal lendingrate

Source: IFS, June 2003

Who Drives Rates?

.00

.04

.08

.12

.16

.20

1975 1980 1985 1990 1995 2000

US

GermanyEuroarea

Source: IFS, June 2003

Testing for Convergence

i i i itU S

tU S

t k t kU S

kj 1 0 1 1 1 1 11( )*

1 1 11 k t k tkj i e *

i i r it tU S

t k t kU S

kj* *( ) 2 0 2 1 1 2 11

2 1 21 k t k tkj i e *

Results

Panel B 96m01-03m04/05

US

Germany

99m01-03m04/05

US

Euro Area

Φ 0.013 0.021* 0.004 0.029** Lag 2 2 2 2 N 88 88 52 53 Adj.R2 0.34 0.18 0.46 0.31 Q-stat(6) 5.983 10.946* 3.866 5.591 Q-stat(12) 9.546 15.226 7.948 7.982

Table 1: Nom. Money mkt. rates

Longer Horizons

• Less linkage expected (liquidity issues, political risk)

• Evolution over time (dismantling of capital controls)

• Empirical literature

Convergence in Long Term Rates

.00

.04

.08

.12

.16

.20

1975 1980 1985 1990 1995 2000

US

Germany

Japan

UK

Source: BIS, July 2003

US, Germany, France

-.06

-.04

-.02

.00

.02

.04

.06

.08

.10

1975 1980 1985 1990 1995 2000

earlysample

latersample

US

Germany

France

Source: BIS, July 2003, and author’s calculations

US, Italy, Spain

-.12

-.08

-.04

.00

.04

.08

.12

1975 1980 1985 1990 1995 2000

earlysample

latersample

US

Italy

Spain

Source: BIS, July 2003, and author’s calculations

Estimation

1 1 11 k t k tkj r *

r r r rtU S

tU S

t k t kU S

kj 1 0 1 1 1 1 11( )*

r r r rt tU S

t k t kU S

kj* *( ) 2 0 2 1 1 2 11

2 1 21 k t k tkj r *

Results: 1973-95

US Ger. US Fra. US Italy US Spain Panel A 73q1-95q4 Φ -0.05 0.04* -0.04 0.11*** 0.04 0.09** -0.03 0.12*** Lag 2 2 2 2 2 2 2 2 N 92 92 92 92 92 92 69 69 Adj.R2 0.04 0.00 -0.01 0.11 -0.01 0.22 -0.03 0.19 Q-stat(4) 4.95 4.49 5.11 15.17*** 3.56 1.1 4.3 2.67

Table 2: Long term real rates

Results: 1996-2003

US Ger. US Fra. US Italy US Spa US Euro Area

Panel B 96q1-03q2 Φ -0.16 0.21** -0.57*** 0.03 -0.18* 0.05 -0.17* 0.16** -0.37** 0.12* Lag 4 4 2 2 4 4 4 4 3 3 N 30 30 30 30 30 30 30 30 30 30 Adj.R2 0.05 -0.03 0.20 -0.00 -0.06 0.09 0.12 0.10 0.15 0.16 Q-stat(4) 1.81 1.54 0.29 7.52 1.13 1.3 2.35 1.93 1.4 4.46

Table 2: Long term real rates

Panel Results

Fixed Effects SUR

US Euro Area US

Euro Area

Panel A 73q1-95q4 Φ -0.018 0.092*** 0.001 0.100*** Lag 2 2 2 2 N 327 327 327 327 Adj.R2 -0.01 0.12 -0.05 0.12 Panel B 96q1-03q2 Φ -0.025*** 0.092* -0.028 0.128** Lag 2 2 2 2 N 120 120 120 120 Adj.R2 0.08 0.07 -0.04 0.06 Panel C 99q1-03q2 Φ -0.524*** 0.140 -0.089 0.157* Lag 2 2 2 2 N 72 72 72 72 Adj.R2 0.14 0.13 -0.02 0.11

Table 3: Long term real rates

Determinants of Real Interest Rates

• 1988-2002

• Annual data

• Debt, expected debt

• Cyclical factors

• Foreign factors (interest rate, global debt)

Estimation

i d E d dt t t t t t 0 1 2 3 2( )

4 5 ,y i ut tW

t

Results

US Germany France Italy Spain UK Constant -0.001 -0.122*** -0.022 -0.081 -0.043* -0.034 (0.008) (0.038) (0.027) (0.041) (0.023) (0.030) Inflation 1.00 1.00 1.00 1.00 1.00 1.00 debt ratio 0.060** 0.182*** 0.027 0.109 0.031 0.067 (0.019) (0.047) (0.040) 0.062) (0.051) (0.044) Exp. change 0.144** 0.112*** 0.177** 0.324** 0.289*** 0.066 in debt ratio (0.061) (0.032) (0.073) (0.106) (0.048) (0.110) output gap 0.388** 0.608** 0.252 0.297 0.218 -0.316 (0.174) (0.219) (0.202) (0.484) (0.223) (0.324) Foreign interest rate 0.096 1.529*** 0.923*** 0.390 1.204*** 0.815** (0.122) (0.327) (0.241) (0.446) (0.145) (0.348) N 15 15 15 15 15 15 Adj.R2 0.32 0.51 0.82 0.77 0.82 0.55 DW 2.24 2.50 2.47 1.70 2.47 1.44

Table 5: Determinants of long term real rates

Panel Results

(1) (2) (3) (4) (5) (6) Inflation 1.469*** 1.097*** 1.167*** 1.00 0.992*** 1.00 (0.251) (0.218) (0.172) (0.196) debt ratio -0.029 0.072*** 0.057** 0.048** 0.138*** 0.064*** (0.027) (0.022) (0.023) (0.020) (0.031) (0.020) expected change 0.091 0.122* 0.088 0.112** 0.081 0.130** in debt ratio (0.089) (0.070) (0.054) (0.049) (0.052) (0.053) output gap -0.025 0.142 0.218 (0.179) (0.163) (0.223) Foreign interest rate 1.117*** 1.093*** 1.138*** 0.923*** (0.167) (0.155) (0.142) (0.208) G-7 debt ratio -0.380*** (0.061) 2 yr ahead G-7 -0.061 debt ratio (0.038) N 60 60 60 60 60 60 Adj.R2 0.76 0.88 0.88 0.65 0.88 0.65

Table 6: Determinants of European long term real rates

Interpretation

• Debt matters

• Expected debt sometimes matters

• Output gap not consistently important

• US interest rates matter for European countries

• Global debt doesn’t enter as expected

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

Implications

.30

.35

.40

.45

.50

.55

.60

.65

.020

.025

.030

.035

.040

.045

.050

.055

1988 1990 1992 1994 1996 1998 2000 2002

Projectedtwo-year-aheaddebt to GDP ratio

Long termreal interestrate

Source: OECD, BIS and author’s calculations