External MPC Unit Discussion Paper No. 30
We construct a measure of the short-term world interest rate using principal component analysis. Drawing on real interest rate data for 18 OECD countries for the period 1985–2008, persistent deviations from the world interest rate that cannot be explained by movements in the real exchange rate are documented. A theoretical model predicts that these unexplained deviations capture foreign exchange rate risk premia. Using panel data techniques, we test the theoretical prediction that a rise in conditional consumption growth volatility relative to the rest of the world reduces the foreign exchange rate risk premia and, therefore, the real interest rate. Our main result is that we find a robust and significant negative relation between the volatility in consumption growth and the level of real interest rates relative to the world interest rate, supporting this hypothesis. We also look at the relation between real interest rates and the net foreign asset position. We test the hypothesis that the empirical negative relation between the two variables captures the relation between real interest rates and macroeconomic volatility, on the one hand, and macroeconomic volatility and the net foreign asset position, on the other hand. We are not able to reject this hypothesis.