Revisiting the real interest rate mechanism

The pro-cyclical effect of real interest rates is a well-known impediment to market-based adjustment to asymmetric shocks in a monetary union. This real interest rate mechanism has been at work in the euro area since its inception, partially offsetting the stabilising effect of the relative price mechanism discussed in the previous chapter. Member States with stronger cyclical positions than the rest of the euro area have experienced comparatively higher inflation rates and as a result lower real interest rates. These real interest rate differences have tended to reinforce cyclical differences via the investment channel. Before the global financial crisis, nominal interest rates were converging as a result of financial integration, while persistent inflation differentials were the main cause of significant Member State differences in real interest rates. Since the crisis, real rate differentials have been magnified by a rise in nominal interest rate dispersion due to financial fragmentation. This has added a nominal component to the traditional real interest rate mechanism. Given the dominant role of bank loans in financing the euro area economy, this chapter assesses the importance of this new nominal component by looking at the drivers of lending rates for households and non-financial corporations. Econometric analysis shows that the divergence in bank lending rates since the global financial crisis can be explained not only by the perceived redenomination risks at the height of the euro area debt crisis but also by country-specific factors, including divergences in sovereign spreads, in domestic activity and in the quality of bank balance sheets. The identified effects of sovereign spreads and bank balance sheets on lending rates should be mitigated by past or ongoing policy and governance changes in EMU. However, the link between lending rates and domestic activity is likely to persist. Therefore, the nominal magnifier of the traditional real interest rate mechanism should not be seen as a temporary effect of the euro area debt crisis but rather as an integral part of adjustment in EMU although its magnitude is expected to be lower in the future in the absence of perceived redenomination risk.