Global real interest rate dynamics from the late 19th century to today

Abstract

There is a long-standing economic debate to what extent interest rates are determined by domestic versus international forces. Using a time series factor model, we estimate two common global factors for the short-term real interest rate for a panel of 17 advanced economies from 1871 to 2013. Our analysis shows that more than 50% of the variation in national real interest rates can be explained by our two international factors alone. While our data encompasses several macroeconomic regime changes, we find in general that real interest rates are more responsive to international conditions during times of high international capital mobility, such as the post Bretton Woods period. Our first common global factor can be interpreted as an approximation of the global short-term equilibrium real interest rate. Using an error-correction approach, we show that that the global real interest rate acts as a force of attraction for national real interest rates. Moreover, our factor analysis can also explain the long-term downward trend of national real interest rates that started in the 1980s, meaning that the forces of secular stagnation have acted on a global level. Finally, we estimate a Panel-VAR model, which allows us to show that the national business cycle is highly responsive to our two common global factor variables, thus indicating that small economies have increasing difficulties to insulate themselves from international macroeconomic conditions. Our analysis is important insofar as it shows that during periods of high capital mobility Central Banks might have even less influence in setting the domestic short-term real interest rate than what is commonly assumed by most neo-keynesian macroeconomic models.