Chart Of The Week   July 25 2022

Europe: In Search Of A Neutral Rate

European Growth

BTPs have become attractive for long-term rather than short-term investors.

The differences between the neutral rates across the Eurozone are the key factor limiting how far and how fast the ECB may increase rates. It is also the main reason why the ECB resorts to an alphabet soup of non-interest rate policy measures (APP, PEPP, LTRO and, now, TPI) to maintain appropriate monetary conditions across the bloc.

But exactly how wide are the differences between the neutral rates? To answer this question, the team estimates the neutral real interest rate – or “r-star” – in Germany, France, Italy, and Spain.

Their methodology produces estimates of r-star that range from 0% in Germany, to -0.8% in Italy, or a GDP-weighted average of -0.3% for the Eurozone.

They also ran a second set of estimates for r-star, which includes total nonfinancial debt-to-GDP. This adjustment changes the picture considerably. While Germany’s real neutral rate of interest remains around 0%, those of Italy and Spain plunge to -1.8% and -2.4%, respectively. France has also experienced a large decline in its r-star to -2.1% in response to the heavy debt load carried by its private and public sectors. Using this method, the GDP-weighted Euro Area r-star falls to -1.4%.

The differences in r-star across Europe mean that the ECB will be forced to activate the TPI before year-end in order to hike interest rates further. Practically, this means that medium- to long-term investors should overweight Italian bonds at the current level of spreads. Short-term investors should remain on the sidelines; the political situation in Italy is still dangerous, and speculators are likely to test the ECB’s resolve.