eco TV Week

The complex relationship between financial conditions, nominal and real interest rates

5/6/2022

Financial conditions reflect whether monetary policy acts as a support to growth or as a headwind. They can be assessed by looking at the level of short and long-term interest rates, corporate bond spreads, the exchange rate. Sometimes equity markets and bank lending survey data are also taken into account.

William DE VIJLDER

TRANSCRIPT // The complex relationship between financial conditions, nominal and real interest rates : May 2022

Financial conditions reflect whether monetary policy acts as a support to growth or as a headwind. They can be assessed by looking at the level of short and long-term interest rates, corporate bond spreads, the exchange rate. Sometimes equity markets and bank lending survey data are also taken into account. The level of interest rates is the most important determinant of financial conditions because it determines the cost of borrowing and credit growth is the key channel of transmission of monetary policy. This raises the question whether we should look at nominal or real interest rates. Intuitively, one would focus on the latter, inspired by common wisdom that inflation makes debt cheaper. However, this supposes that, year after year, your income increases with inflation.  If your nominal income does not change, you should use nominal interest rates. Considering that in the US and the euro area, wage growth is lagging inflation, it is more appropriate to use the former when calculating real interest rates. This approach reminds us of the considerable dispersion of the effective real interest rate between euro area countries and, within a given country, between households.  This provides an argument for rapidly bringing inflation under control.

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