Interpreting spillovers: the ECB, Fed interest rate hikes, and the persistence of dollar dominance

We review the literature on the empirical characteristics of the global financial cycle and associated stylized facts on international capital flows, asset prices, risk aversion and liquidity in the financial system. We analyse the co-movements of global factors in asset prices and capital flows with commodity prices, international trade and world output as well as the sensitivity of different parts of the world to the Global Financial Cycle. We present evidence of the causal effects of the monetary policies of the US Federal Reserve, the European Central Bank and of the People's Bank of China on the Global Financial Cycle. We then assess whether the 2008 financial crisis has altered the transmission channels of monetary policies on the Global Financial Cycle. Finally, we discuss the theoretical modelling of the Global Financial Cycle and avenues for future research.

The Global Financial Cycle

The Global Financial Cycle

Central Banks in Parliaments: A Text Analysis of the Parliamentary Hearings of the Bank of England, the European Central Bank and the Federal Reserve

Parliamentary hearings are a fundamental tool to hold independent central banks accountable. However, it is not clear what type of information central banks provide when they communicate with parliaments. In this article, we compare the communication of the European Central Bank (ECB) in parliamentary hearings to its communication in the press conferences. Using text analysis on the ECB President’s introductory statements in parliamentary hearings and press conferences from 1998 to 2021, we show that the ECB uses hearings to discuss topics that are less covered in press conferences. We also find that the ECB’s policy stance in the hearings tend to reflect the stance in press conferences, and that the degree of language complexity is similar in the two fora. These findings suggest that the ECB mainly uses parliamentary hearings to further explain policy decisions first presented at press conferences but also to put them in a broader context.

The Euro Crisis: Mission Accomplished?

Although the literature has studied the role of the Federal Reserve as the global lender of last resort in 2007–09, many aspects of the Dollar Swap Lines to the European Central Bank need further exploration. Accordingly, we provide original evidence about the auction operations, allotted amounts and interest rates with regard to the Federal Reserve’s dollar swaps and the European Central Bank’s dollar provision. More specifically, we examine the demand side of the Dollar Swap Lines (whereas the existing literature mentions the supply side only) and we scrutinise the interest rate (whereas the literature concentrates on volumes) set by the Federal Reserve, and also the rate set by the European Central Bank. Our findings cast light on the nature of the relationship between the Federal Reserve and the European Central Bank. Finally, we contribute to the literature on the global lender of last resort by coining the notion of the financial dilemma, under the dollar system within a framework of globalised financial markets.

Key Issues for Monetary Policy: An ECB View

Previous articleNext article FreeTaylor Rule Exchange Rate Forecasting during the Financial CrisisTanya Molodtsova and David H. PapellTanya MolodtsovaEmory University Search for more articles by this author and David H. PapellUniversity of Houston Search for more articles by this author PDFPDF PLUSFull Text Add to favoritesDownload CitationTrack CitationsPermissionsReprints Share onFacebookTwitterLinked InRedditEmailQR Code SectionsMoreI. IntroductionThe past few years have seen a resurgence of academic interest in out-of-sample exchange rate predictability. Gourinchas and Rey (2007, using an external balance model); Engel, Mark, and West (2008, using monetary, Purchasing Power Parity [PPP], and Taylor rule models); and Molodtsova and Papell (2009, using a variety of Taylor rule models) all report successful results for their models vis-à-vis the random walk null. There has even been the first revisionist response. Rogoff and Stavrakeva (2008) criticize the three abovementioned papers for their reliance on the Clark and West (2006) statistic, arguing that it is not a minimum mean squared forecast error statistic.An important problem with these papers is that none of them use real-time data that was available to market participants.1 Unless real-time data is used, the "forecasts" incorporate information that was not available to market participants, and the results cannot be interpreted as successful out-of-sample forecasting. Faust, Rogers, and Wright (2003) initiated research on out-of-sample exchange rate forecasting with real-time data. Molodtsova, Nikolsko-Rzhevskyy, and Papell (2008) use real-time data to estimate Taylor rules for Germany and the United States and forecast the Deutsche mark/dollar exchange rate out-of-sample for 1989:Q1 to 1998:Q4. Molodtsova, Nikolsko-Rzhevskyy, and Papell (2011), henceforth MNP (2011), use real-time data to show that inflation and either the output gap or unemployment, variables which normally enter central banks' Taylor rules, can provide evidence of out-of-sample predictability for the US dollar/euro exchange rate from 1999 to 2007. Adrian, Etula, and Shin (2011) show that the growth of US dollar-denominated banking sector liabilities forecasts appreciations of the US dollar from 1997 to 2007, but their results break down in 2008 and 2009.Molodtsova and Papell (2009) conduct out-of-sample exchange rate forecasting with Taylor rule fundamentals, using the variables, including inflation rates and output gaps, that normally comprise Taylor rules. Engel, Mark, and West (2008) propose an alternative methodology for Taylor rule out-of-sample exchange rate forecasting. Using a Taylor rule with prespecified coefficients for the inflation differential, output gap differential, and real exchange rate, they construct the interest rate differential implied by the policy rule and use the resultant differential for exchange rate forecasting. We use a single equation version of their model, which we call the Taylor rule differentials model.2 Since there is no evidence that either the Fed or the European Central Bank (ECB) targets the exchange rate, we do not include the real exchange rate in the forecasting regression for either model.3Out-of-sample exchange rate forecasting with Taylor rule fundamentals received blogosphere, as well as academic, notice in 2008. On July 28 and September 9, Menzie Chinn posted on Econbrowser a discussion of in-sample estimates of one of the specifications used in an early version of MNP (2011).4 On August 17, he posted an article by Michael Rosenberg of Bloomberg, who discussed Taylor rule fundamentals as a foreign currency trading strategy. By December 22, however, optimism had turned to pessimism. Once interest rates hit the zero lower bound, they cannot be lowered further. With zero or near-zero interest rates for Japan and the United States, and predicted near-zero rates for the United Kingdom and the Euro Area, the prospects for Taylor rule exchange rate forecasting were bleak. A second theme of the post, however, was that there was nothing particularly promising on the horizon. Going back to the monetary model, even in a regime of quantitative easing, faced doubtful prospects for success.5The events of 2007 to 2009 focused the attention of economists on the importance of financial conditions. On August 9, 2007, the spread between the dollar London interbank offer rate (Libor) and the overnight index swap (OIS), an indicator of financial stress in the interbank loan market, jumped from 13 to 40 basis points on concerns that problems in the subprime mortgage market were spreading to the broader mortgage market.6 The spreads mostly fluctuated between 50 and 90 basis points until September 17, 2008, when they spiked following the announcement that Lehman Brothers had filed for bankruptcy, peaking on October 10 at over 350 basis points. Following the end of the panic phase of the financial crisis in October, 2008, the spread gradually returned to near precrisis levels in September 2009. The spread increased again, although not nearly as sharply, in mid-2010 and late 2011. The spreads are depicted in figure 1.Fig. 1. Credit spreads and financial stress indexes with their differentialsView Large ImageDownload PowerPointThe deteriorating financial situation in late 2007 and 2008 inspired several proposals for linking monetary policy to financial conditions. Mishkin (2008) argued that, when a financial disruption occurs, the Fed should cut interest rates to offset the negative effects of financial turmoil on aggregate economic activity. McCully and Toloui (2008) suggested that, because of tightened financial conditions, the Fed needed to lower the policy rate by 100 basis points in early February 2008 in order to keep the neutral rate constant. Meyer (2009) argued that the Taylor rule without considerations of financial conditions could not explain aggressive Fed policy in early 2008.Taylor (2008) proposed adjusting the systematic component of monetary policy by subtracting a smoothed version of the Libor-OIS spread from the interest rate target that would otherwise be determined by deviations of inflation and real GDP from their targets according to the Taylor rule. He argued that such an adjustment, which would have been about 50 basis points in late February 2008, would be a more transparent and predictable response to financial market stress than a purely discretionary adjustment.Curdia and Woodford (2010) modify the Taylor rule with an adjustment for changes in interest rate spreads. Using a dynamic stochastic general equilibrium (DSGE) model with credit frictions, they show that incorporating spreads can improve upon a standard Taylor rule, although the optimal size of the adjustment is smaller than proposed by Taylor and depends on the source of variation in the spreads.The spread between the euro interbank offer rate (Euribor) and the euro OIS also jumped in August 2007 and spiked in September and October 2008, although not by as much as the US spread. While the Euribor-OIS spread came down in September 2009, it did not return to its precrisis levels. During August and December 2010, the spread jumped to as high as 40 basis points and, in December 2011, reached a maximum of 100 basis points. The end-of-quarter Libor-OIS, Euribor- OIS, and the difference between the Libor-OIS and Euribor-OIS spreads are depicted in figure 1. After the gap between the two spreads narrowed in 2008:Q4, the spread turned against the Euro Area, reaching a maximum in 2011:Q3 and 2011:Q4 before narrowing in 2012:Q1.This paper investigates out-of-sample exchange rate forecasting during the financial crisis with Taylor rule-based models that incorporate indicators of financial stress. We use one-quarter-ahead forecasts and estimate models with core inflation and both the output gap and the unemployment gap for the Taylor rule fundamentals and Taylor rule differentials models.7 When the Libor-OIS/Euribor-OIS differential is included in the forecasting regression, we call the models spread-adjusted Taylor rule fundamentals and differentials models. According to these models, when the Libor-OIS spread increases, the Fed would be expected to either lower the interest rate or, if it had already attained the zero lower bound, engage in quantitative expansion, depreciating the dollar. When the Euribor-OIS spread increases, the ECB would be expected to react similarly, depreciating the euro. We therefore use the difference between the Libor-OIS and Euribor-OIS spreads in addition to the difference between the United States and Euro Area inflation rates and output gaps for out-of-sample forecasting of the dollar/euro exchange rate.Another widely used credit spread is the Ted spread, the three-month Libor/three-month Treasury spread for the United States and the three-month Euribor/three-month Treasury spread for the Euro Area. As shown in figure 1, the US Ted spread was generally higher than the Euro Area Ted spread until 2008 and the Ted spread differential was more variable than the Libor-OIS/Euribor-OIS differential. The Euro Area Ted spread spiked with the US Ted spread in 2008:Q3, and so the differential does not display a spike at the peak of the financial crisis. Subsequent to the financial crisis, the Ted spread differential is similar to the Libor-OIS/Euribor-OIS differential. It turns against the Euro Area in 2009, reaches a maximum in 2011:Q3 and 2011:Q4, and narrows in 2012:Q1. We use the difference between the US and Euro Area Ted spreads as an alternative indicator of financial stress.Financial Conditions Indexes (FCIs) that summarize information about the future state of the economy contained in a number of current financial variables have received considerable attention in recent years. Hatzius et al. (2010) show that FCIs outperform individual financial variables that are considered to be useful leading indicators in their ability to predict the growth of different measures of real economic activity. We therefore augment the Taylor rule by using the difference between the Bloomberg and Organization for Economic Cooperation and Development (OECD) FCIs for the United States and the Euro Area for out-of-sample forecasting of the dollar/euro exchange rate.8 The Bloomberg and OECD FCIs are depicted in figure 1 where, in contrast to the credit spreads, an increase represents an improvement in financial conditions. Financial conditions deteriorate sharply for both the United States and the Euro Area in late 2008, but turn in favor of the United States starting in 2009.Real-time data for the United States is available in vintages starting in 1966, with the data for each vintage going back to 1947. Real-time data for the Euro Area, however, is only available in vintages starting in 1999:Q4, with the data for each vintage going back to 1991:Q1. While the euro/dollar exchange rate is only available since the advent of the euro in 1999, "synthetic" rates are available since 1993. We use rolling regressions to forecast exchange rate changes starting in 1999:Q4, with 26 observations in each regression. Keeping the number of observations constant, we report results ending in 2007:Q1, with 30 forecasts, through 2012:Q1, with 50 forecasts. We report the ratio of the mean squared prediction errors (MSPE) of the linear and random walk models and the CW test statistic of Clark and West (2006).9The Taylor rule fundamentals model with the unemployment gap produces very strong results. The MSPE of the Taylor rule model is smaller than the MSPE of the random walk model and the random walk null can be rejected in favor of the Taylor rule model using the CW test at the 5 percent level for the initial set of forecasts ending in 2007:Q1. As the number of forecasts increases, the MSPE ratios decrease and the strength of the rejections increases, peaking at the 1 percent level in 2008:Q1. In the following quarter, 2008:Q2, the MSPE ratios start to rise and continue to increase through 2009:Q1 (although the rejections continue at the 5 percent level or higher). Starting in mid-2009, the MSPE ratios stabilize and the random walk can be rejected in favor of the Taylor rule model at the 5 percent significance level for all specifications between 2009:Q2 and 2012:Q1.The results for the other models are not as strong. For the Taylor rule differentials model with the output gap, the random walk null can be rejected at the 10 percent level or higher from 2007:Q1 to 2008:Q3 and 2009:Q2 to 2009:Q4, but not otherwise. For the Taylor rule fundamentals model with the output gap and the Taylor rule differentials model with the unemployment gap, the random walk null can only be rejected at the 10 percent level or higher from 2007:Q1 to 2008:Q2.A major innovation in this paper is to incorporate indicators of fi-nancial stress, measured by the difference between the Libor-OIS and Euribor-OIS spreads, the US and Euro Area Ted spreads, the US and Euro Area Bloomberg FCIs, and the US and Euro Area OECD FCIs, for out-of-sample exchange rate forecasting with Taylor rule models. The strongest results are again for the Taylor rule fundamentals model with the unemployment gap. Using the OECD FCI, the random walk null can be rejected in favor of the linear model alternative at the 5 percent level for all but one set of forecasts, and at the 10 percent level for the remaining forecast. Using the three other indicators, the null can be rejected at the 10 percent level or higher for over half of the forecasts, with the strongest results for the forecasts ending between 2007 and 2009. As with the original Taylor rule model, the augmented Taylor rule differentials model with the output gap is the next most successful, with the random walk null rejected at the 10 percent level or higher for all forecasts using the OECD FCI and at the 10 percent level or higher for over half of the forecasts with the three other indicators. The rejections for the other two augmented models are concentrated in 2007 and 2008.We proceed to compare the original and augmented models for the two most successful specifications. For the Taylor rule fundamentals models with the unemployment gap, the original model null can be rejected in favor of the augmented model alternative at the 5 percent level for virtually every set of forecasts ending between 2007:Q1 to 2008:Q2 for all four financial stress indicators. For the forecasts ending between 2008:Q3 and 2012:Q1, however, the original model null is never rejected. For the Taylor rule differentials model with the output gap, there is some evidence in favor of the alternative specification with the Ted spread, Bloomberg FCI, and OECD FCI.We also compare the out-of-sample performance of the Taylor rule models with the monetary, PPP, and interest rate differentials models. For the interest rate differentials model, the MSPE ratios are below one and the random walk can be rejected with the CW tests from 2007:Q1 to 2008:Q2. Starting with the panic period of the financial crisis in 2008:Q3, the MSPE ratios rise above one and the random walk null can only be rejected for the forecasts ending in 2009:Q1 and 2012:Q1. The monetary and PPP models cannot outperform the random walk for any forecast interval. The evidence of out-of-sample exchange rate predictability is much stronger with the Taylor rule models than with the traditional models.II. Exchange Rate Forecasting ModelsEvaluating exchange rate models out of sample was initiated by Meese and Rogoff (1983), who could not reject the naïve no-change random walk model in favor of the existent empirical exchange rate models of the 1970s. Starting with Mark (1995), the focus of the literature shifted toward deriving a set of long-run fundamentals from different models, and then evaluating out-of-sample forecasts based on the difference between the current exchange rate and its long-run value. Engel, Mark, and West (2008) use the interest rate implied by a Taylor rule, and Molodtsova and Papell (2009) use the variables that enter Taylor rules to evaluate exchange rate forecasts.A. Taylor Rule Fundamentals ModelWe examine the linkage between the exchange rate and a set of variables that arise when central banks set the interest rate according to the Taylor rule. Following Taylor (1993), the monetary policy rule postulated to be followed by central banks can be specified aswhere it is the target for the short-term nominal interest rate, πt is the inflation rate, is the target level of inflation, yt is the output gap, the percent deviation of actual real GDP from an estimate of its potential level, and R is the equilibrium level of the real interest rate.10According to the Taylor rule, the central bank raises the target for the short-term nominal interest rate if inflation rises above its desired level and/or output is above potential output. The target level of the output deviation from its natural rate yt is 0 because, according to the natural rate hypothesis, output cannot permanently exceed potential output.The target level of inflation is positive because it is generally believed that deflation is much worse for an economy than low inflation. The unemployment gap, the difference between the unemployment rate and the natural rate of unemployment, can replace the output gap in equation (1) as in Blinder and Reis (2005) and Rudebusch (2010). In that case, the coefficient γ would be negative so that the Fed raises the interest rate when the unemployment rate is below the natural rate of unemployment. Taylor assumed that the output and inflation gaps enter the central bank's reaction function with equal weights of 0.5 and that the equilibrium level of the real interest rate and the inflation target were both equal to 2 percent.The parameters and R in equation (1) can be combined into one constant term, , which leads to the following equation, where λ = 1 + ϕ. Because λ > 1, the real interest rate is increased when inflation rises, and so the Taylor principle is satisfied. Following Taylor (2008) and Curdia and Woodford (2010), the original Taylor rule can be modified by subtracting a multiple of the spread between the dollar Libor rate and the OIS rate, where st is the spread.We do not incorporate several modifications of the Taylor rule that, following Clarida, Galí, and Gertler (1998), are typically used for estimation. Lagged interest rates are usually included in estimated Taylor rules to account for either (a) partial adjustment of the federal funds rate to the rate desired by the Federal Reserve, or (b) desired interest rate smoothing on the part of the Federal Reserve. Since the most successful exchange rate forecasting specifications for the dollar/euro rate in MNP (2011) did not include a lagged interest rate and Walsh (2010) shows that the Federal Reserve lowered the interest rate during the financial crisis faster than would be consistent with interest rate smoothing, we do not include lagged interest rates. The real exchange rate is often included in specifications that involve countries other than the United States. Since there is no evidence that the ECB uses the real exchange rate as a policy objective and inclusion of the real exchange rate worsens exchange rate forecasts in MNP (2011), we do not include it. Finally, while inflation forecasts are often used on the grounds that Federal Reserve policy is forward looking, there is no publicly available data on euro area core inflation forecasts.To derive the Taylor rule based forecasting equation, we construct the implied interest rate differential by subtracting the interest rate reaction function for the Euro Area from that for the United States: where asterisks denote Euro Area variables and α is a constant. It is assumed that the coefficients on inflation and the output gap are the same for the United States and the Euro Area, but the inflation targets and equilibrium real interest rates are allowed to differ.11Based on empirical research on the forward premium and delayed overshooting puzzles by Eichenbaum and Evans (1995), Faust and Rogers (2003) and Scholl and Uhlig (2008), and the results in Gourinchas and Tornell (2004) and Bacchetta and van Wincoop (2010), who show that an increase in the interest rate can cause sustained exchange rate appreciation if investors either systematically underestimate the persistence of interest rate shocks or make infrequent portfolio decisions, we postulate the following exchange rate forecasting equation:12where asterisks denote Euro Area variables, ω is a constant, and ωπ, ωy, and ωs are positive coefficients. Alternatively, the unemployment gap differential (with opposite sign) can substitute for the output gap differential in equation (5).The variable et is the log of the US dollar nominal exchange rate determined as the domestic price of foreign currency, so that an increase in et is a depreciation of the dollar. The reversal of the signs of the coefficients between (4) and (5) reflects the presumption that anything that causes the Fed and/or ECB to raise the US interest rate relative to the Euro Area interest rate will cause the dollar to appreciate (a decrease in et). Since we do not know by how much a change in the interest rate differential (actual or forecasted) will cause the exchange rate to adjust, we do not have a link between the magnitudes of the coefficients in (4) and (5).13The difference between the US and Euro Area Ted spreads, Bloomberg FCIs, and OECD FCIs can also be used as the measure of the spread differential. An increase in the US spreads relative to the Euro Area spreads would cause forecasted dollar depreciation. Because the FCIs are constructed so that an increase represents an improvement in financial conditions, the sign of the coefficient on the FCI differentials would be negative so that a relative deterioration in US financial conditions would still lead to forecasted dollar depreciation.B. Taylor Rule Differentials ModelEngel, Mark, and West (2008) propose an alternative Taylor rule based model, which we call the Taylor rule differentials model to differentiate it from both the interest rate differentials model and the Taylor rule fundamentals model. They posit, rather than estimate, coefficients for the Taylor rule and subtract the interest rate reaction function for the Euro Area from that for the United States to obtain implied interest rate differentials,where the constant is equal to zero, assuming that the inflation target and equilibrium real interest rate are the same for the United States and the Euro Area. Out-of-sample exchange rate forecasting is conducted using single equation and panel error correction models.14We estimate a variant of the Taylor rule differentials model with two measures of economic activity–OECD estimates of the output gap and the unemployment gap. In order to obtain an implied interest rate differential that corresponds to the implied interest rate differential (6) with the unemployment gap as the measure of real economic activity, we use a coefficient of -1.0. This is consistent with a coefficient of 0.5 on the output gap if the Okun's law coefficient is 2.0.The Taylor rule differential model using Taylor's original coefficients would have a coefficient of 1.5 on the inflation differential, 0.5 on the output gap differential, and would not include the real exchange rate.15 During 2009 and 2010, a number of commentators, most notably Rudebusch (2010), argued that the appropriate output or unemployment gap coefficient in the Taylor rule for the United States should be double the coefficient in Taylor's original rule. While there has been an active policy debate on the normative question of whether prescribed Taylor rule interest rates should be calculated using Taylor's original specification or with larger coefficients, it is clear that the latter provide a better fit for Fed policy in the 2000s.16 Since the same argument has not been made for the ECB, we implement this by estimating a Taylor rule differentials model with a coefficient of 1.0 on the output gap (or -2.0 on the unemployment gap) for the United States and 0.5 on the output gap (or -1.0 on the unemployment gap) for the ECB, where α is a constant.The implied interest rate differential can be used to construct an exchange rate forecasting equation, where, as in the Taylor rule fundamentals model, the signs of the coefficients switch and we do not have a

The response to the global financial crisis (GFC) of 2007–2008 has famously been described as the problem of too-big-to-fail.1 In the middle of a worsening crisis, financial regulators had to recognize that bank bailouts were the only way to stabilize financial markets. One of the two priorities of regulatory reforms post-crisis was to address the too-big-to-fail problem by introducing a resolution procedure for systemically important financial institutions.2 Among financial regulators (with the notable exception of the USA), contingent convertible bonds (CoCos) were seen as a major innovation to address the too-big-to-fail problem and quickly became a popular “bail-in” instrument to facilitate the instant recapitalization of a distressed bank. The quick deleveraging that could be achieved with CoCo conversions would serve the dual roles of recapitalizing “a going-concern bank” and reducing the resolution costs for a “gone concern” bank. During the press conference on March 19, 2023 the Swiss Financial Market Supervisory Authority (FINMA) announced that, as part of the emergency package in response to the loss of trust and the run on Credit Suisse, the contingent convertible bonds that were part of the Credit Suisse Additional Tier 1 (AT1) regulatory capital had been written off.3 The decision by FINMA took many by surprise and provoked a flood of negative market commentary, with the commonly stated view that conversion violated the priority order of claims between debt and equity. Indeed, in the final rescue deal, the shareholders of Credit Suisse retain around $3 billion of equity value, while the CoCo bond principal write-down amounted to a wipeout of $17 billion for CoCo investors. Implicitly corroborating this commentary, the European Central Bank (ECB), the Bank of England, and other regulators made public statements on the Monday following the Credit Suisse deal that they do not intend to follow the FINMA approach and that they intend to respect the usual priority order of claims in resolution.4 How can these divergent views of regulators be reconciled? Why did the Credit Suisse AT1 CoCo bondholders face losses before shareholders were wiped out? What are the lessons for the effectiveness of post-GFC too-big-to-fail reforms? This article provides clarification of these important questions. CoCo bonds are designed to absorb losses of a distressed going-concern bank at conversion, thereby helping to capitalize the bank. Their primary purpose is to reduce the need for a capital injection by the government in times of crisis when nobody else is willing to provide additional external capital. Such public support is costly to taxpayers and exacerbates moral hazard. CoCo bonds have two main contract features: the loss absorption mechanism and the trigger that activates that mechanism (illustrated in Graph 1).5 CoCos can absorb losses either by converting into common equity or through a principal write-down (partial or full). The trigger can be either mechanical (i.e., defined in terms of a capital ratio) or discretionary (subject to supervisory judgment). The trigger defines the point at which the loss absorption mechanism is activated. The mechanical trigger activates the loss absorption mechanism when the capital of the CoCo-issuing bank drops below a pre-specified fraction of its risk-weighted assets. The bank's equity capital can be measured either based on book value or market value. The discretionary, or point of non-viability (PONV), trigger is activated based on the supervisor's assessment of the bank's possible insolvency. PONV triggers give regulators authority to convert, if and when they decide that the issuer has reached that state. Because the PONV is difficult to determine ex ante, PONV triggers introduce uncertainty about the timing and circumstances leading to the activation of the loss absorption mechanism by the regulator. CoCo bonds typically have more than one trigger. In case of multiple triggers, the loss absorption mechanism can be activated when any trigger is breached. Under Basel III rules, all regulatory capital CoCos are required to have a discretionary PONV trigger. The activation of the discretionary trigger, which was present in all CoCos issued by Credit Suisse, was exactly what allowed FINMA to write down Credit Suisse AT1 capital instruments on March 19, 2023. The loss absorption mechanism is the second contract feature of CoCos. Once the trigger is activated, CoCos can be either converted to equity at a pre-defined conversion rate or subject to a principal write-down. In either case, the conversion delevers the bank and/or boosts its equity capital ratio. For conversion to equity CoCos, the conversion rate can be based either on the market price of the stock at the time of conversion, or on a pre-specified price, like the stock price at the time of issuance. It is also possible to have a combination of market price and prespecified price floor, where the latter defines the floor for the conversion rate and hence protects existing equity holders from unlimited dilution. The various options for setting the conversion price lead to different exposures to dilution risk for existing equity holders, and thus create varying incentives to avoid conversion by existing equity holders. In the case of the principal write-down CoCos, the haircut can be either full or partial. However, most of the principal write-down CoCos of Credit Suisse were full write-down CoCos. The write-down CoCos potentially encourage risk taking by managers acting in the interest of shareholders. The regulatory treatment of CoCos under Basel III and the supplementary requirements of national regulators shape the design choices of CoCo contract features of issuing banks (that can be seen in Graph 2). Under the Basel III framework, CoCos must satisfy two requirements to qualify as regulatory capital. The first requirement, which applies to both AT1 and T2 instruments, is satisfied by the PONV trigger. The second requirement is the going-concern rule, which specifies that the minimum trigger level of CET1/RWA to qualify as AT1 is 5.125%. In addition, AT1 instruments must be perpetual. Importantly, these features are not necessarily outcomes of optimal financial contracting between the issuer and its investors. The regulatory rationale for CoCos is to improve banks’ resilience to financial shocks by strengthening their capital buffers in a crisis, while also providing investors with an investment opportunity that is distinct from debt and equity. By issuing CoCos, banks can raise capital while limiting the dilution costs of current shareholders at issuance and reduce the likelihood of becoming insolvent or requiring a government bailout. In particular, CoCos allow banks to seamlessly recapitalize during times of financial stress. The conversion or write-down of CoCos allows the bank to transfer some of the losses to CoCo investors, ensuring that the costs of bank failures are borne by investors rather than taxpayers. In addition to reducing the cost of distress, the possibility of CoCo conversion provides bankers with incentives to limit the probability of distress. CoCos can be an attractive investment opportunity for long-term investors who understand and are able to take losses in a crisis. CoCos typically offer higher yields than traditional bonds due to their contingent nature, their low priority ranking (on par or even lower than equity investors), and the high systematic component in their risk. Because institutional mandates often block traditional fixed income investors from taking positions in conversion to equity CoCos, the market yield on the instruments may also contain a premium for sophisticated and flexible investors in terms of market segregation. In their 2013 Primer on CoCos published by the Bank for International Settlements, colleagues Stefan Avdjiev, Anastasia Kartasheva, and Bilyana Bogdanova show that the yield-to-maturity of newly issued CoCos are on average 2.8% higher than the subordinated debt, and 4.7% higher than the senior unsecured debt, of the same bank.6 However, the popularity of CoCos could also be partly driven by the search for yield in a low interest rate environment, which have been touted by financial advisors that sometimes misrepresented the product as a relatively safe way of boosting yield. CoCos are often perceived as similar to total loss absorbing capacity (TLAC) instruments, since they are also financial instruments designed to “bail-in” troubled systemically important banks. There are, however, key differences between the two. The primary purpose of CoCos is to delever a bank amid a crisis, by writing down debt or providing equity capital, or both. CoCos are thus designed to maintain the equity cushion of a going concern bank. TLAC, which are usually T2 capital, are additional loss absorption requirements for global systemically important banks (GSIBs) like Credit Suisse to enable a single point of entry resolution. The goal of TLAC is to ensure that the holding companies of systematically important banks have sufficient capacity to absorb losses so that their operating affiliates can continue operating without putting their liabilities at risk. By contrast, CoCo conversion could take place while the bank is still a going concern. A 2020 article in the Journal of Financial Economics we wrote with Stefan Avdjiev and Bilyana Bogdanova provides the first comprehensive analysis of bank CoCo issuance.7 Out of the 731 Coco issues raising over $500 billion between 2009 and 2015, European issues took the largest share (39%), while U.S. was absent from the list. At the time of the Credit Suisse trigger event, the global AT1 CoCos market was estimated to be $254 billion.8 About 56% of these CoCos include a mechanical trigger. Though in the first years of our sample mandatory conversion CoCos were prevalent, principal write-down CoCos have become more popular over time, eventually dominating the market. Finally, slightly more than half (55%) of the CoCos up to 2015 were classified as AT1 capital, while most of the T2 CoCos tend to be issued by banks in emerging economies. Our 2020 Journal of Financial Economics article also shows that the propensity to issue a CoCo is higher for larger and better capitalized banks. Presumably only relatively healthy banks, with remote conversion risk, are able to issue CoCos at a reasonable cost. Another reason is that the principal beneficiaries from a CoCo issue are senior bondholders, whereas shareholders expose themselves to dilution risk. The same JFE article shows that the CDS spreads of CoCo issuers decline upon the announcement of a CoCo issue, indicating that they generate risk-reduction benefits and lower costs of debt. While the average reduction in CDS spread was 2.7 basis points, the drop was more prominent for conversion CoCos (5.0 bps), including those with mechanical triggers (3.3 bps). Conversion CoCos with mechanical triggers are also associated with a reduction of 6.2 bps in CDS spreads. Only Additional Tier 1 instruments contributed to the reduction of CDS. Finally, CoCo issuances have no statistically significant impact on the issuers’ stock prices, except for the case of principal write-down CoCos with high trigger levels, which involve no dilution risk for shareholders and for which stock price responses have been significantly positive on average. Such a contrast suggests a potential moral hazard on shareholders’ part to take excess risk, since the cost will be first borne by the holders of write-down CoCos. CoCos that convert to equity offer a superior design from the point of view of reducing bank fragility. In the case of Credit Suisse, all outstanding CoCos were principal write-down CoCos, and this is the reason why their investors received no equity stake in the merger with UBS. Had they issued conversion to equity CoCos, they would have received shares in the merged company. The collapse of Silicon Valley Bank (SVB) on March 10, 2023 sent shockwaves through the financial system and quickly drew investors’ attention to the prominent weaknesses at Credit Suisse, which was impelled to seek up to CHF 50bn in liquidity support from the Swiss National Bank (SNB) on March 16, 2023. This dramatic move failed to quash speculation, or slow down deposit withdrawals, to the extent that 2 days later the SNB and FINMA announced that they had begun proceedings to organize a takeover of Credit Suisse by UBS. The Swiss financial regulatory authorities had decided that the best way to avert another GFC was to rescue Credit Suisse through a merger with a strong financial institution, following the playbook of the Federal Reserve and US Treasury in 2008 with its rescue of Bear Stearns through a merger with JPMorgan and what has colloquially become known as the “Jamie deal” in reference to the CEO of JPMorgan.9 It is revealing to contrast these two deals, as the contexts are different and the limits on the legal authorities of regulators are different. The Federal Reserve and Treasury did not have nearly the same authority to push through a merger as the Swiss government under the Swiss emergency law. The Federal Reserve had to invoke section 13(3) of the Federal Reserve Act to claim authority to provide liquidity support “under unusual and exigent circumstances” to a broker-dealer. Beyond the authority to provide liquidity support the Federal Reserve (and US Treasury) had no means other than moral suasion to get the management of Bear Stearns and JPMorgan to agree to merge at a proposed price of $2 per Bear Stearns share. They had no authority to sidestep shareholder agreements at both Bear Stearns and JPMorgan, and they could not write down Bear Stearns liabilities outside Chapter 11 bankruptcy. The only way the deal could be structured outside bankruptcy was as a purchase-and-assumption deal whereby JPMorgan agreed to assume all Bear Stearns liabilities. However, even at the price of $2 per share, this was seen as too risky by JPMorgan management and might not receive the blessing of JPMorgan shareholders. To overcome this hurdle the Federal Reserve agreed to back up the deal by setting up an innovative collateralized special purpose vehicle—Maiden Lane LLC. This vehicle would be financed with a junior tranche of $1 billion from JPMorgan and a $29 billion senior tranche of the Federal Reserve, and it would purchase up to $30 billion worth of troubled assets of Bear Stearns, thereby de-risking the Bear Stearns balance sheet. The Federal Reserve and Treasury also had to make concessions to Bear Stearns shareholders by eventually raising the share price to $10.10 Although this deal was in and back some in financial a later a similar merger between and the The Swiss regulatory authorities were in a better to a deal between Credit Suisse and UBS. They could shareholder a resolution of and they did not have to public at risk by setting up a special purpose vehicle to the Credit Suisse balance sheet. they had to do was trigger the write-down of Credit Suisse CoCos that had been designed and issued for a contingent FINMA did that, that government support Credit will trigger a write-down of the value of all AT1 shares of Credit Suisse in the of around and thus an in The principal write-down of these AT1 instruments allowed for a of the Credit Suisse balance sheet. that one of the main of the Bear Stearns and later in the of has been that the of in all these a moral hazard in in this the write-down of the Credit Suisse AT1 bonds would not only the Credit Suisse balance also market that of systemically important financial would be in a crisis. Although the write-down of Credit Suisse CoCos following the rescue of Credit Suisse was it in financial and a crisis in the AT1 bond market. in Credit Suisse AT1 bonds were that their bonds had been written down even Credit Suisse shareholders the first in the CoCo To many as we have this to be an of a and of at the Financial market is to be by a of the of and by the decision to an equity deal at the of bond There had been a of a similar CoCo write-down in when was over by in that case shareholders had been wiped so that was at an that part of the that equity the most junior had been It is not investors who were also financial regulators outside potential in the billion AT1 bond of the quickly on that a resolution in the European we would follow the and we to it to the investors, to avoid to be we have no to respect this the Monday following decision the with the and issued the common equity instruments are the first to absorb and only their full would Additional Tier 1 be required to be written This approach has been in and will continue to the of the and in crisis from and regulatory only to It was only a of a days before of The and quickly announced that a was in the Credit Suisse rescue as “a resolution up as a and on the and responses that has when other regulators and point that in a resolution would have investors like the and of a global in that, this is to can trust any debt issued in or for that if can the are made to be did in the terms ex and the of AT1 most of the CoCos issued by Credit Suisse are principal write-down CoCos with similar For the CoCo issued in on the following based on Credit Suisse ratio. a or to a a the full principal of the will be and written and of the in the for the of and The that will if Credit Suisse common equity 1 by its risk assets as of any balance in the case of of these instruments, other by is below and FINMA has not agreed in writing to of CET1/RWA that a full conversion or as not it is satisfied that circumstances or have or will the of the CET1/RWA to a level that it to be In addition, the following will if either FINMA that it has that a conversion or of the with the conversion or of claims in respect of all other regulatory capital instruments issued by a of the Credit Suisse that, to their terms or by of are of converted into equity or at that time, to improve capital are at the time or an requirement to from becoming or to a part of its as they or from to on its or to improve capital at the time or an of support from the public and in the that or will the of capital and without in the of would have become to a part of its as they due or to on its The of either or both of these two is also to as the of or the The additional Credit Suisse on AT1 bonds “under FINMA has the to proceedings with respect to under Swiss is subject to the resolution under Swiss and if the have not been subject to a could convert the into equity or the in case, in or in be that, in the case of any conversion into FINMA would follow the order of priority under Swiss which other that the would have to be converted to the conversion of any of subordinated debt that not qualify as regulatory capital with a write-down or conversion in the case of any FINMA may not be required to follow any order of which other that the could be in or in part to the of any or all of equity are not to FINMA its authority under these to trigger conversion it that Credit Suisse had reached the The Credit Suisse CoCos were not “gone concern” CoCos concern” CoCos. By these CoCos, FINMA the AT1 as they were to to allow for a recapitalization so that Credit Suisse could be back to a point insolvency. A first has been by and FINMA on that the AT1 bond write-down was and that FINMA did not in the collapse of up on Credit Suisse with both its stock price and its CDS spread Financial an in investors’ perceived probability of a and the announcement of the billion from the SNB did not these Though investors the possibility that could be a on Credit Suisse as in the CDS the below suggests that investors did not a write-down of AT1 bonds on the of the takeover of Credit Suisse It is difficult to what of investors the possibility of a write-down of AT1 bonds even if shareholders were not wiped the of the Credit Suisse CoCo bond issued in in these bonds higher interest than bonds as for the risk of a write-down. higher investors in a low interest rate environment, and their high yields were part of a major like this one in by a Credit Suisse the of CoCo market a yield of around even European bonds in at around so we still value in subordinated financial bonds The average European bank would need to of its capital to investors in AT1 bonds may not have been of the they were that CoCos were as issued by systemically important financial might also be of the that CoCos are junior to equity. This is for the view by the CEO of banks market AT1 bonds as and get with the yields on The surprise of decision can also be seen in the AT1 bond market following the write-down. the below was a in this market in the days following the Credit Suisse in addition to the of the contingent of CoCos. the market has since for the CoCo write-down in was no of CoCo conversion one could from the Credit Suisse CoCos as CoCo conversion or write-down up the balance of a bank in and stabilize financial could only and our analysis in our 2020 Journal of Financial Economics article could at only what investors at the time of issuance. the Credit Suisse only one many lessons can be from this The first is that the way CoCos have been structured is a of some sophisticated investors to have been about the between going-concern and CoCos. often did not that was a and for those who it was not to the The of going concern CoCos is to allow the bank could by a that before equity investors are wiped Another of that to a of uncertainty in the Credit Suisse is the of multiple triggers, an trigger when a capital is and a discretionary trigger that the financial could if it that the issuer had reached the This to and costly It also the risk of to investors. One of the with the discretionary trigger is what the PONV is have been regulators ex and to regulatory The that the and that they had to that they did not intend to from priority to the AT1 bond market is revealing of the extent of regulatory that is in these instruments, which to the and discretionary triggers, and their the in the probability of a CoCo There are no financial that can be to price these contingent with decision to write down Credit Suisse AT1 the by the and and the in the AT1 bond market following the write-down have the market for this important instrument and of capital for banks. It would be a if the of the Credit Suisse were the of CoCos from bank regulatory capital when the Credit Suisse CoCos have their for a and which the of the merger deal with and so Swiss taxpayers to losses from Credit In its decision FINMA also a healthy financial in AT1 bond by investors that their investment the first of risk and that due is before in these and of CoCo is with all the around the Credit Suisse One design that has been in the of of CoCos following the financial crisis that is worth is the CoCo design proposed by one of the present with in our article in The proposed design has main and The more is a CoCo without or discretionary trigger, an for the issuer to convert the claim into equity. Under this the CoCo-issuing bank would in purchase a to issue equity at a pre-specified price, as to the convertible bonds for which the the conversion This is the design for a going-concern It is not a for debt a capital for the issuing bank. It in a of in equity that the issuing bank to raise equity capital at terms in a crisis. In with we that a capital the costs of holding an equity capital for banks by to raise equity capital only when it is at a cost. Because this CoCo design is structured as a convertible bond collateralized for the the optimal conversion point is based on and thus the of the CoCo is an a uncertainty and around the instrument is Another of this instrument is that it provides a to equity capital. The CoCo bond the issuer the to issue capital at terms in a difficult time, often in and thus its equity capital This CoCo design in a of capital with the that the issuer can decide when it is to thus the on regulators to decide when it is to the equity capital under this design the issuer the CoCo into equity when the equity value is thereby recapitalizing the bank and strengthening its balance when it is Finally, the convertible CoCo design the of the in the conversion decision (and all the associated legal as is the case due to the discretionary trigger requirements of AT1 capital instruments under Basel In the of the Credit Suisse CoCo investors have the Swiss regulatory authority for a rescue that to investors’ assets following the Credit Suisse takeover by The collapse of Credit Suisse an important for financial their to up resolution for the the and of of resolution has so the risk of a like Credit Suisse that the Swiss regulatory authorities decided that a purchase and deal with by the SNB was to the Financial at the between the Swiss regulatory authorities and Credit Suisse on March where the SNB the CHF 50bn they also another will merge with and before This is not a on the would have been a for the financial system and the of around the another at the were also a is not for the Swiss we on the we would and one of the of the Swiss Federal in an with the that Credit Suisse have an financial a systemically important bank be up to the to this would be In however, the would be The of Credit Suisse would have other banks into the one this The is that financial regulators must the current approach to the too-big-to-fail problem and resolution. What is the point of TLAC and if when push to regulators a over resolution. One important positive of the Credit Suisse crisis, however, is that it has that $17 billion of CoCos can be written without the system into the This quick and debt write-down has some way in the too-big-to-fail problem and has significantly the cost of Credit Suisse for the Swiss all the too-big-to-fail the Credit Suisse CoCos did their financial on the of contingent capital like CoCos that can be activated to a bank's regulators also need to the of CoCo in terms of their conversion mechanism and their trigger triggers that are in CoCos offer regulators a possibility to in the middle of the crisis. the regulatory it difficult to price the risk of conversion as we in thereby the effectiveness of In we proposed an CoCo providing the issuing bank an to convert into are more and flexible instruments designed to give banks the opportunity to recapitalize during a crisis, and they are more to price the trigger is at the of the and CoCo requirements that enable recapitalization of a troubled bank be the of regulators in and in the and

In the 4 years of its existence, the European Central Bank (ECB) has made significant contributions to the macroeconomic stability of the euro area. This paper takes a critical look at the ECB and compares its institutional structure, policy framework, and operational procedures with those of the longer-established US central bank. We discuss the implications of various differences between the ECB and the Federal Reserve with a view toward identifying successful elements of the practices of both these institutions. The paper recommends that the ECB abandon the first pillar of its monetary policy strategy that affords a special role to monetary aggregates in the evaluation of financial market conditions. It also suggests that the Federal Reserve should follow the ECB's lead and provide an explicit definition of price stability. Copyright 2003, Oxford University Press.

The European Central Bank (ECB) has received a lot of criticism for its too little, too late performance to ease market pressures during the economic crisis. At the same time, the ECB and the Federal Reserve (FED) have managed the new economic realities that have emerged in the international context differently. Despite the criticisms, the European Central Bank is the European Union institution that has assumed more control due to the new model of economic governance of the EU. Why did the Federal Reserve act so nimbly and quickly to calm the markets, while the ECB was so cautious in managing monetary policy? The aim of this paper is to perform a comparative analysis of the management of interest rates and other monetary policy measures undertaken by the Central Bank and the Federal Reserve during the economic crisis, as well as to understand the changes in the context of the ECB and the emergence of its authority within the European Union’s economic governance model since 2011. Thus, in order to carry out a scrupulous exposition, we will also limit the time frame of this study to the 2007-2014 period.

According to a review of "Central Banks: Monthly Balance Sheets", prepared by the consulting company Yardeni Research, Inc., the assets of the four leading central banks in the world - the US Federal Reserve (FED), the European Central Bank (ECB), the Bank of Japan and the People's Bank of China (PBOC), increased by 4.8 times over the specified period. Consequently, the liabilities of the big four central banks increased by 4.8 times. As it is known, the bulk of the Central Bank's liabilities is money issued by central banks (in the form of cash and deposits, on which commercial banks place their funds). Therefore, the money supply issued by four banks in a quarter of a century has also increased by 4.8 times. The FED was especially distinguished by the fact that it began to sharply increase the issue of money in the midst of the financial crisis of 2008-2009. This was done under the flag of "quantitative easing" (QE). There were three "quantitative easing" programs, the last one ended in 2014. However, when the US declared a "pandemic" and began to impose quarantine restrictions, the Fed's printing press was again launched at full capacity. Now the Fed buys $ 120 billion a month in the securities market ($ 80 billion in US Treasury securities and another $ 40 billion in mortgage securities). Accordingly, the dollar supply is increasing by the same amount every month. The Bank of Japan is on the second place in terms of the growth rate of assets (and money supply). It began to build up assets and money supply earlier than other leading central banks, from the end of the 20th century to the beginning of the 21st century. At the end of February 2021, the picture has changed radically. We see a rapid rise in the value of the indicator at the Bank of Japan, at the turn of 2018-2019. It crossed the 100% bar. Now its assets are equal to 127.4% of GDP. The indicators of the relative level of assets of the Fed and the ECB have grown very much. But the Central Bank of China has reduced the relative value of its assets by about a third. This is both the result of curbing the activity of the Chinese Central Bank and the fact that China has experienced high rates of GDP growth. As for the other three leading central banks, their policy of increasing money supply will continue. The head of the US Federal Reserve, Jerome Powell, makes it clear that the US Central Bank, at least until the end of the year, will continue to buy securities in the same volumes (that is, $ 120 billion a month). ECB President Christine Lagarde said in March that the bank would accelerate asset purchases in the coming months under the Pandemic Emergency Purchase Program (PEPP). The volume of this program is 1.85 trillion EUR. In addition, the main ECB repurchase program continues to operate. Other central banks that are not included in the survey by Yardeni Research, Inc. are also pursuing an asset buildup course. Among them are the Bank of England and the Swiss National Bank. Leading central banks of the world, to justify the runaway money emission, refer to the "pandemic". The more money supply is created, the more likely it is that this currency will have a lower rate in relation to the competitor's currency. And the undervalued exchange rate of the national currency is a means of strengthening the international competitiveness of national business. However, such competition can lead to the collapse of the currencies of rival central banks

This chapter explores how the European Central Bank (ECB) responded to the 2008 global financial crisis and the 2020 COVID-19 crisis. Akin to what the US Federal Reserve did, the ECB reacted to both the 2008 and 2020 crises by increasing liquidity and loosening monetary policy, including through the adoption of controversial quantitative easing programs. Nevertheless, similar to the US Fed, the ECB expanded its remit to include social goals by elevating the fight against climate change and making it one of its policy priorities. Despite the ECB's policy responses ultimately matching those of its US counterpart, the dominant view is that the ECB was a slower and more reluctant responder than the Fed. This peculiar pattern is largely attributed to the technocratic character of the institution. That is, the ECB's behavior reflects the dominance of neoliberal and ordoliberal ideas among European monetary authorities and the attendant policy prescription that emphasizes price stability over growth and employment.

Previous articleNext article FreeCommentVeronica GuerrieriVeronica GuerrieriUniversity of Chicago and NBER Search for more articles by this author PDFPDF PLUSFull Text Add to favoritesDownload CitationTrack CitationsPermissionsReprints Share onFacebookTwitterLinked InRedditEmailQR Code SectionsMoreA classic theme in monetary economics is the crucial role of the credibility of central banks for the effectiveness of monetary policy. This raises two important questions. First, can we measure the evolution of the credibility of a central bank? Second, how can a central bank establish credibility? Goldberg and Klein propose a novel empirical analysis to test the evolution in credibility of the European Central Bank (ECB) between January 1999 and mid-2005. The nice feature of their work is that they use market responses to elicit information about the ECB credibility. Their main conclusion is that over this time period, the credibility of the ECB has increased whereas the credibility of the Federal Reserve Bank has been relatively stable. Moreover, looking at the history of policies implemented by the ECB in the same time period, they argue that the ECB credibility increase was linked to its policy actions.First, they present a standard New Keynesian model, following Gürkaynak, Sack, and Swanson (2005), to analyze the effect of an increase in the central bank’s credibility on the response of the yield curve to news. Then, they use high-frequency asset price data to test the time variation in the response of European and American yield curves to inflation news.In particular, they focus on term spreads between 10-year and 2-year interest rates for German, French, Italian, and U.S. government bonds and on the euro-dollar exchange rate. They look at the change in these term spreads and in the exchange rate 30 minutes before and after each monthly release of the U.S. core consumer price index (CPI). The news component is defined as the difference between the actual release value and the markets’ prior expectation of this release. Owing to data restrictions, the authors cannot use inflation news for each specific country, but they argue that the U.S. core CPI also contains news about inflation in euro area countries.Using these data, Goldberg and Klein show that there has been a significant persistent time variation in the response of the European term spreads to inflation news, but not in the response of the term spread for the United States. Their interpretation of these results is that the credibility of the ECB has increased over time after its foundation, whereas the credibility of the Federal Reserve Bank has been relatively stable between 1999 and 2005 under the Greenspan presidency. Finally, following a methodology developed by Müller and Petalas (2010), Goldberg and Klein estimate the path of the response of the European term spreads over time and compare it to the pattern of ECB policies and announcement, concluding that they were critical for the increase in credibility of the ECB.Main mechanism. Let me first present a stripped-down version of the model to clarify the main mechanism behind the effect of news on the yield curve. The model can be represented by the following two equations:The first equation represents the monetary policy rule, which is a simplified version of a Taylor rule: the central bank responds only to inflation. In particular, ϕ captures the responsiveness of monetary policy to inflation and represents the central bank’s type. A central bank is more credible when the agents in the economy believe that it is more aggressive in response to inflation, that is, when they believe that ϕ is higher. The second equation is a simple version of a Phillips curve with a backward-looking component. That is, current inflation is negatively related to the current interest rate (because of the negative relation between interest rate and demand) but positively related to past inflation. Finally, εt is an independently and identically distributed shock to inflation.Combining (1) and (2), we can write the interest rate asso that the higher ϕ is, the more the short-term interest rate reacts to an inflation shock. Moreover, we can write the process for inflation asThis shows that if a central bank has a higher ϕ, not only does inflation respond less to a shock to current inflation because of the response of the interest rate but also its response is less persistent.Next, we can calculate the forward rateand the two-period maturity interest rateWe can then define the term spread, which is equal to the slope of the yield curve, asIn this simplified model, the yield curve is on average flat (as πt fluctuates around zero), which is not typically the case in the real world, but it is possible to extend the model to introduce risk premia and/or liquidity premia so as to have a positively sloped yield curve. In any case, the object of interest in the paper is not the average term spread but its response to an inflation shock, that is,It is easy to check that dqt/dεt is decreasing in ϕ; that is, the response of the term spread to inflation shocks is smaller when ϕ is higher. This is the key implication of the model behind the empirical strategy of Goldberg and Klein. The central finding of the paper is that dqt/dεt for the euro area has declined between November 1999 and October 2000. In light of the model, the authors interpret this as the result of an increase in ϕ (or in the ϕ perceived by the market); that is, the ECB has become more credible over that time period. The authors link this increase in credibility to the fact that between November 1999 and October 2000, the ECB increased the interest rate seven times. However, it is important to notice that dqt/dεt is the difference between two elements, dit,2/dεt and dit/dεt, and it is less clear that in the data they separately behave as they should. The theory predicts that when the central bank is more aggressive (ϕ increases), the response of the short-term interest rate should increase and the one of the long-term interest rate should decrease because inflation is less persistent. Figure 4 in their paper shows that while the response of the 10-year interest rate decreases in that time period for all three European countries, the response of the 2-year interest rate increases significantly only in Germany, slightly increases in France, and decreases in Italy.Interpretation of empirical findings. Let me now turn to the interpretation of the main empirical result in the paper. As described above, the authors find persistent time variation in term spreads for European bonds in contrast to no significant variation for the U.S. bonds. In terms of the model outlined above, this would be consistent with an increase in ϕ over time. However, it is not clear how such a pattern should be interpreted.A simple story behind an increase in ϕ could be that the ECB has changed type over time; that is, it was less aggressive when it was founded, but it gradually became more responsive to inflation shocks. However, this does not seem the interpretation that the authors have in mind. The story that they pursue is that the central bank has always been aggressive, but agents did not believe that it was at the beginning of its activity. However, observing its policies, agents have gradually learned that the ECB was an aggressive type; that is, the ECB credibility has increased over time.I think that Goldberg and Klein’s interpretation is very appealing, and it would be nice to deepen the analysis in that direction. The model considered in the paper, as the simple model sketched above, does not allow to separate the agents’ beliefs about the central bank’s type from the truth. One could develop a model along the lines of the one outlined above in which the central bank mechanically follows a simple Taylor rule with a fixed ϕ, but the agents in the economy do not know the value of ϕ and start with a prior below its true value. To avoid agents learning ϕ in one period, the model should be enriched with monetary shocks that make learning more gradual. This would probably imply what the authors suggest: as the agents’ beliefs about ϕ increase, the response of the term spread decreases.Finally, it would be interesting to explore a richer model of reputation in which the central bank behaves strategically. What I have in mind is a simple signaling model in which the central bank has a fixed type that is unknown to the agents. A central bank with a higher type cares more about inflation. Hence, to form beliefs about inflation, agents have to form beliefs about the bank’s type. My guess is that there may be a separating equilibrium in which a high-type bank at the beginning would behave even more aggressively just to signal its type, whereas a low-type bank would never sacrifice too much output to gain in lower inflation. This suggests that if the ECB policy was initially more aggressive than later, this may be due to the desire of building up credibility. It would be nice to estimate a simple Taylor rule to see if indeed the residual at the beginning of the ECB life were positive.ReferencesGürkaynak, Refet, Brian Sack, and Eric Swanson. 2005. “The Sensitivity of Long-Term Interest Rates to Economic News: Evidence and Implications for Macroeconomic Models.” American Economic Review 95, no. 1 (March): 425–36.First citation in articleGoogle ScholarMüller, Ulrich, and Philippe-Emmanuel Petalas. 2010. “Efficient Estimation of the Parameter Path in Unstable Time Series Models.” Review of Economic Studies 77, no. 4 (October): 1508–39.First citation in articleGoogle Scholar Previous articleNext article DetailsFiguresReferencesCited by Volume 7, Number 12011 Article DOIhttps://doi.org/10.1086/658317 Views: 92 © 2011 by the National Bureau of Economic Research. All rights reserved.PDF download Crossref reports no articles citing this article.