Real Interest Rates and the Crisis: Where are the Rates Headed?
This paper examines the likely direction of real interest rates in the Euro area and the United States from April 2009 on. It is argued that the crisis that began in 2007 and the ensuing recession changed the descending trend in real interest rates which started a long time ago. If real interest rates were to rise too much, private and public finances, housing markets and stock markets would suffer particularly in the countries where the past credit binge and the crisis response has made debts mount, thus prolonging the current crisis. Economic theory should help shed light on the likely future direction of long-term real interest rates. In the paper, growth models are briefly discussed and shown to offer disparate predictions about the level of real interest rates in a growing economy and little practical guidance. Monetary theories, i.e. theories explicitly focused on the role of interest rates in balancing supply and demand in the single markets of the economy, make reference to some normal or natural level of real interest rate but obviously suffer from the difficulties of estimating such normal or natural levels both in general and particularly in a unusually dynamic and uncertain situation such as the current one. The more pragmatic approach, consisting in the assessment of the relevant single components of the long-term real nominal interest rate over the cycle, points to the risks of a surge in the risk premium as well as in expected short-term real interest rates and thus to a prolongation of the current economic contraction.
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Web page: http://www.unive.it/dip.economia
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