The Euro Area and World Interest Rates

We analyze the behavior of world interest rates, focusing on the ramifications of European Monetary Union. Our analysis indicates that nominal US interest rates tend to drive European rates at both the short and long horizons. There is some evidence that US rates are becoming increasingly influenced by European rates, but the relationship is still far from symmetric, despite EMU. We also investigate the empirical determinants of real interest rates over the past decade and a half. Real US interest rates also have an influence upon European rates, although German rates do not appear to have a similar effect upon US rates. Conditioning on foreign interest rates, we find that real interest rates on government debt depend significantly upon current and expected levels of debt, in Europe as in the US. It follows that if US and European budget deficits continue to grow more rapidly than official forecasts, interest rates will rise. What had previously been a strong effect on US interest rates has been diluted by the addition of 2004 to the sample, perhaps reflecting the effect of massive purchases of US securities by foreign central banks.