Our extended interest rate model offers possible explanations for key interest rates, money market rates and long-term interest rates in the eurozone and the US that offer a high level of adaptability to the actual developments. The main results are set out below.
Munich, Nov 16, 2016
The Fed's "new normal": the US Federal Reserve's pattern of behavior has changed considerably during the course of the financial crisis. Today, the Fed is probably assuming a much lower natural interest rate than it was before the crisis. If the reaction pattern we have identified for the period from 1990 to 2008 were to apply, then the US key rate would currently come to around 3.5%.
Shift in ECB policy: the start of QE saw the ECB switch from a relatively stable pattern of behavior in terms of interest rate policy to an even more expansive course. While it was fairly easy to follow the ECB's interest rate policy reaction pattern from 2000 onwards based on inflation developments and the output gap, it will be virtually impossible to explain key interest rates of zero in the future in an environment where capacity utilization is close to normal and inflation is expected to pick up.
QE effect on long-term rates significant, but not uniform: the impact of quantitative easing on US long-term interest rates in the period from 2009 to 2013 does not reveal a uniform pattern. QE actually served more to push interest rates up initially. What is more, until only recently, low inflation expectations were responsible for nudging US long-term interest rates down. In the eurozone, the unconventional measures taken by the ECB have played a key role in determining the yield level. It is estimated that the ECB's bond purchases have shaved almost 60 basis points off the yield on ten-year bonds.
Current pattern of behavior could result in extremely low interest rates sticking around for some time to come: if the Fed remains true to its current behavior pattern, then, based on assumptions that appear to be plausible, it is likely to lift the federal funds rate only very slightly to 1% between now and the end of 2018. US long-term interest rates will have risen to 2.6% by the end of 2018. German long-term interest rates will also have risen to only around 1.5% by the end of 2018.
Central banks are free to decide how quickly they want things to return to normal: if the Fed and the ECB abandon their very expansionary stance more quickly than expected, then our calculations suggest that the upward trend in yields on the bond market would be much more pronounced. The previous behavior patterns would justify a key rate hike to almost 3% in the US and over 2% in the eurozone by the end of 2018. In this alternative scenario, the US long-term rate rises to 3.2% and its German counterpart to 2.2% by the end of 2018.