Abstract
This paper addresses the extent to which the ECB rate setting responded to inflation and monetary growth in the run up to, and during, the financial crisis of the late 2000s. The analysis covers the period between 1999:01 and 2013:12, split into pre-crisis and financial crisis periods using a structural break test. In addition, a number of specifications are examined, including those in which only positive or negative policy rate changes are used as the dependent variable. An ordered probit model is used as it is deemed more appropriate for modelling discrete economic behaviour, such as policy rate changes, than continuous time series methods. The results from the pre-crisis period show that, although the monetary aggregate was significant in models that incorporate all the policy changes, but when considering just positive policy rate changes, the coefficient for monetary growth is not only small, but also statistically insignificant. Hence, this casts doubt on the extent to which monetary growth influenced the ECB policy rate decisions prior to the financial crisis. The monetary growth coefficients for the crisis period are also found to be insignificant. However, unlike during the pre-crisis period, the coefficient for inflation is found to be both positive and statistically significant, thus confirming qualitative perceptions that the ECB prioritised its price-stability mandate over concerns that the Euro Area sovereign debt crisis.
Highlights
The ECB’s monetary policy strategy hinges on a numerical definition of price stability and a two-pillar method of analysing risks to price stability
This paper addresses the extent to which the ECB rate setting responded to inflation and monetary growth in the run up to, and during, the financial crisis of the late 2000s
Price stability is defined by the ECB Governing Council as a growth rate in the Harmonised Index of Consumer Prices (HICP) of close to, but below, 2 %
Summary
The ECB’s monetary policy strategy hinges on a numerical definition of price stability and a two-pillar method of analysing risks to price stability. A monetary policy reaction function, on the other hand, outlines the response of the central bank’s policy decisions (short-term interest rate changes) to changes in economic variables such as the output gap and inflation. Estimates for the two subsample periods are carried out and compared with the whole period’s results This enables us to separate the analysis into whether the ECB’s interest setting behaviour changed during the crisis or not, and which factors were more important in influencing the bank’s monetary policy strategy in each. The Taylor rule, which was introduced above, is the most common reaction function that has typified monetary policy setting behaviour of the banks Such rules address issues of time inconsistency and promote transparency in monetary policy decisions.
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