Did the global financial crisis affect the structural relationship between policy rates and inflation in the Eurozone and United States?

Abstract

The relationship between inflation and short-term nominal interest rates plays a significant role in the application of monetary policy. One of the primary reasons for the relationship’s importance is the monetary authority’s ability to stimulate or reduce economic activity to control inflation through policy rates. However, using interest rates to manage inflation requires a clear cause-and-effect relationship. Inflation and nominal interest rates have been on a downward trend since the 1980s. However, after the global financial crisis, both inflation and nominal interest rates were at simultaneous record lows, with policy rates seemingly unable to stimulate the economy and cause a corresponding rise in prices. This thesis examines the structural relationship between inflation and nominal interest rates in the case of the eurozone and the United States for data between 1999 and 2019 to make new contributions to the discussion about the relationship between inflation and nominal interest rates after the global financial crisis. The thesis examines the structural relationship between inflation and interest rates by employing structural break tests, a plethora of unit root and cointegration tests, and Granger causality tests. The empirical results find no evidence for a structural break in the relationship between inflation and policy rates for the US. The results do, however, support the existence of a long-term equilibrium relationship between inflation and interest rates in the US, with a uni-directional Granger causality from the policy rate to inflation. Conversely, the thesis finds clear evidence for a structural break in the eurozone’s relationship between inflation and the nominal interest rate while, accordingly, finding little evidence for a long-term equilibrium relationship. There is, however, evidence for a uni-directional Granger causality from inflation to nominal interest rates.