Inflation Expectations and Expected Real Interest Rates as Determinants of Nominal Interest Rates in PIGS

Quantitative easing conducted by European central bank to fight persisting risks of deflation is drawing an attention of increasing number of empirical studies. Moreover, effectiveness of monetary policy at near zero inflation rates reveals lot of issues on whether interest rates really have a lower bound around zero percent. As a result, traditional views on the role of inflation expectations and expected real interest rates in the long-term interest rates determination face the challenge of fundamental revision. In the paper we analyze relative contributions of inflation expectations and expected real interest rates to long-term interest rates on government bonds leading path by employing SVAR methodology. We also decompose these long-term interest rates into transitory and permanent components. Our research revealed significant changes in the relative contribution of inflation expectations and expected real interest rates to the long-term interest rates determination in the periphery countries of the Euro Area in comparison with the core of Euro Area (France and Germany). The crisis period even intensified this trend.