Higher potential growth can also influence real interest rates in the long term as households seek to smooth consumption over time. Higher potential growth generates expectations of higher future income. Households may then want to borrow against expected future income and thereby reduce saving already today. Lower saving implies higher real interest rates. The time preference rate can be looked upon as an expression of households’ impatience in consumption. The higher the degree of impatience, the more households will want to consume today at the expense of future consumption, and the higher the real interest rate has to be in order to provide sufficient savings to meet investment demand. It is important to stress the long-term perspective of this analysis. In the really long term, it is potential growth and saving preferences that determine the relationship between desired saving and desired investment and thereby also the real interest rate. In the short- and medium-term, however, the economy is regularly exposed to shocks that influence economic developments, and thereby also the interest rate. It is not unlikely that we might see sizeable deviations of actual rates from the theoretical rates over longer periods. Such deviations may be exactly what are needed to bring the economy back towards a new and sustainable equilibrium. Moreover, uncertainty and risk premia are often disregarded in the theoretical world. In the real world, different types of risk premia exist that can lead to deviations from these stylised theoretical considerations.
Moreover, with low inflation expectations, the private sector may postpone expenditures, thereby weakening economic activity. In fact, inflation is now below target in most advanced economies. As a result central bankers are asking themselves whether this decline is caused by common shocks, by a coincidence of domestic factors or by structural changes in the reaction of prices to the output gap. While recent price developments in the US and in the UK are largely explained by global disinflationary forces, oil prices, currency appreciation and the sensitivity of inflation to unemployment in a context of ongoing economic recovery,1 my overall assessment regarding the euro area situation is that a sizeable domestic component is at play. This has motivated the bold steps taken by the Eurosystem to counteract the risk of inflation remaining too low for too long a period of time. Part A – What happened to Euro-area inflation Let me now describe recent price developments in the euro area in more detail. HICP inflation has fallen consistently below our target since January 2013, declining from 2% to −0.1% in March 2015. Forecasters have repeatedly been surprised by this evolution. Three main reasons have been put forward to explain this. A first explanation is that forecasting has been complicated by the fall in global crude oil prices and raw materials and its transmission to other sectors. In this regard, recent research conducted at the Banque de France supports this view by showing that forecast errors for oil prices explain about half of the errors for headline inflation.