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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
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