Rising Long-term Interest Rates: Is the European Bond Market Overshooting?

Rather than chronicle recent developments in European long-term interest rates as such, this paper assesses the impact of increases in those interest rates on economic performance and inflation. That puts us in a position to evaluate the economic pressures for further rises in those rates, the first question posed in this assignment, and the scope for overshooting (the second question), and then make some illustrative predictions of future interest rates in the euro area. We find a wide range of effects from rising interest rates, mostly small and mostly negative, focused on investment spending, debt service costs and shrinking fiscal space. There are also countervailing positive effects, which render the net negative effects on spending and the real costs of borrowing relatively small. The illustrative projections, based on techniques derived from an analysis of how financial markets work, agree with that conclusion. Forecasts of long rates for the near future, and of short rates further out, both show a weak tendency to rise further. But they both remain small by historical standards. The recommendation for the ECB is therefore not to react by undertaking any major policy changes till the emerging European recovery is on a firmer basis and capable of overcoming increases in the cost of borrowing and shrinking fiscal space. There is also an implication that worries about rising/overshooting interest rates often reflect the fact that inflation risks are unequally distributed: larger in some places, but offset by their absence elsewhere. That is a matter for domestic policy, not ECB policy (concerned as it is with average European outcomes, not with outcomes in a particular economy).