The ECB's separation principle: does it 'rule OK'? From policy rule to stop-and-go

Abstract

Prior to and during the first stage of the crisis, the ECB's conduct of monetary policy was consistent with the 'separation principle', which refers to the division between monetary and liquidity management policies. However, it became increasingly difficult to apply as interest rates approached their lower-bound. While it was supposed to guide the ECB's exit strategy, the ECB finally resorted to a 'stop-and-go policy'. The separation principle strongly depends upon the institutional setup in which the central bank operates. We show that the difficulties faced by the ECB are due to an important feature of the monetary union, which economic governance is essentially rule-based. The success of a monetary union crucially depends on the strict compliance to the rules. The breach of the rules forced the ECB to stabilize euro area sovereign debt markets, stretching its mandate and altering the efficacy of the separation principle.