The natural interest rate, its drivers, and the future outlook.
Renzo, Brando Di
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This thesis provides a critical analysis of the factors driving the natural interest rate (also referred to as “r*”) in the Euro Area from 1995 to 2017. The research shows how the increased level of savings, shrinking globalization growth, and declining potential output growth are placing downward pressure on the r* of the countries of the Euro Area. The analysis suggests that the Great Recession and the European Sovereign Debt Crisis structurally changed the underlying dynamics of the drivers of the natural interest rate, showing a much stronger effect of the factors for the period following the financial crises. Finally, the stress tests conducted with the OLS model show very little flexibility of the natural interest rate under three different scenarios, namely severely adverse, adverse, and positive/stable scenario. This result raises questions about the effectiveness of the suggested factors in explaining the movements of r*, indicating that the underlying dynamics might be regulated by other factors such as the financial cycle, as proposed by another strand of literature. Concluding, the findings suggest that ECB, policymakers, and investors should keep a close eye on the future evolution of r* as the zero-lower bound appears to be here to stay, at least in the foreseeable future.