Cross-country cash rates

In the Financial Times, Martin Feldstein wrote about the difference between the EU and US monetary setting regimes – specifically he wanted to answer why the EU was lifting rates, while the US had been cutting. (ht Greg Mankiw).

Ultimately, he puts this difference down to a number of factors:

  1. Labour market differences – stronger unions in Europe make a wage-price spiral more likely.
  2. Inflation history – EU has had more episodes of hyperinflation
  3. Age and credibility – EU body is young, this is its first major crisis, still needs to get credibility.

Now these appear to be good reasons why reactions differ between the two countries.

However, just to make this post a little more complete there could be some other reasons why the cash rate may differ between countries:

  1. Time preference – the more we prefer consumption now to the future, the greater interest rates need to be to reduce inflationary pressure (less so for a small country).
  2. Inflation fighting history – if they have been more dovish in the past, they will need higher rates now.
  3. Natural economic growth – the greater the natural growth rate, the higher the interest rate needs to be.
  4. Relative risks in the country – the higher the relative risk in the country, the higher the real interest rate needs to be.
  5. Marginal product of captial – the higher the marginal product of capital, the greater the real interest rate must be.

Anything I’ve missed?

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3 replies
  1. Kiwi Trader
    Kiwi Trader says:

    It is simple.

    The Europeans are worried about inflation.
    The Americans are worried about growth.

    The European Central Bank knows what it’s job is.
    The US Federal Reserve has forgotten what it’s job is.

    It thinks it’s job is to bail out the US financial system from it’s own mistakes.
    Where do you think all the funding comes from? They simply print more US dollars.
    America will have much higher inflation as a result of the current folly.
    US inflation at 6%..and rising, with interest rates at 2%….madness.

    Benanke is more worried about avoiding a recession than preventing inflation expectations taking hold. Greenspan and Volker look very worried.

  2. Matt Nolan
    Matt Nolan says:

    “Benanke is more worried about avoiding a recession than preventing inflation expectations taking hold. Greenspan and Volker look very worried.”

    It will be interesting to see what happens – I’m not happy with negative real interest rates either. They are trying to inflate there way out of a housing collapse 😛

    Greenspan and Volker always look worried – Bernanke must feel like they are his grandparents, constantly telling him about “back in their day”.

    I hate to say it, but I think both of them are a little behind the ball at the moment, and they should try to understand this before they nag Bernanke again – some of the things they say betray a sense of not knowing what is going on

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