Download 6. Conclusions

Msc in Finance and International Business
Department of Business Studies
Author: Cristina Huma
Advisor: Stig Vinther Møller
Financial
stability and
inflation
targeting in the
European Union
An empirical study on Germany
and the EU
November 2010
Aarhus School of Business, Aarhus University
Financial Stability and Inflation Targeting
In the European Union
Huma Cristina
Abstract:
The aim of the thesis is to evaluate the monetary policy in the Euro Area and in the Germany
through the perspective of the Taylor rule. The goal is to determine whether the ECB is
following a strict inflation targeting regime or whether its monetary policy is rather
acommodative. Such a study is welcome, as any analysis on the ECB data is still in its
infancy. The empirical analysis sheds some light on the monetary policy in the Euro Area and
compares the monetary policy of the ECB to that of Bundesbank.
The empirical evidence suggests that the interest rates in the euro area are in line with what
framework would predict, suggesting in the same time a rather accommodative monetary
policy of the ECB. There is a greater weight on the output gap than the focus on inflationary
pressures, in contrast with the Bundesbank monetary policy, which follows a strict inflation
targeting regime. The Taylor rule developed in the thesis finds that productivity developments
and M3 growth have significant influence on the main refinancing rates in the Euro Area.
Key words: Taylor rule, monetary policy, interest rate, Bundesbank, ECB
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Table of Contents
1.
Introduction ..................................................................................................................................... 4
2.
Literature review: ............................................................................................................................ 6
3.
4.
2.1.
Taylor Rules ............................................................................................................................ 6
2.2.
Inflation targeting .................................................................................................................. 12
2.3.
Interest rate smoothing .......................................................................................................... 16
2.4.
Practical issues ...................................................................................................................... 17
2.5.
Credibility.............................................................................................................................. 17
ECB’s vs. Bundesbank’s monetary policy .................................................................................... 19
3.1.
Organization of the ECB ....................................................................................................... 19
3.2.
Tools of the ECB: .................................................................................................................. 19
3.3.
Independence: ........................................................................................................................ 20
3.4.
Monetary policy objectives of the ECB ................................................................................ 20
3.5.
The monetary policy of the Bundesbank: .............................................................................. 24
Sample selection, variables measurement and estimation methodology ....................................... 25
4.1.
Data ....................................................................................................................................... 25
4.2.
Variables measurement ......................................................................................................... 26
4.2.1.
Real GDP ....................................................................................................................... 26
4.2.2.
Inflation rate .................................................................................................................. 27
4.2.3.
Output gap ..................................................................................................................... 28
4.3.
Estimation methodology........................................................................................................ 34
5.
Empirical evidence ........................................................................................................................ 37
6.
Conclusions ................................................................................................................................... 47
7.
Annexes: ........................................................................................................................................ 49
7.1.
Data ....................................................................................................................................... 49
7.2.
Stationarity tests output ......................................................................................................... 55
7.3.
Output gap estimations: ......................................................................................................... 59
7.4.
Equation estimation output .................................................................................................... 61
a.
Euro Area .............................................................................................................................. 61
b.
Germany: ............................................................................................................................... 65
7.5.
Coefficient and residual tests: ............................................................................................... 68
7.6.
VAR evidence: ...................................................................................................................... 70
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Bibliography .................................................................................................................................. 75
1.
Introduction
The present thesis aims to understand better the monetary policy in the Euro Are and the
monetary policy of the Bundesbank, taking into account the main refinancing rates through
the framework developed in the seminal paper of Taylor (1993). Monetary policy models
usually imply the monetary authorities setting a policy instrument (typically a short-term
interest rate) in order to achieve certain objectives. These objectives represent macroeconomic
variables that are subject to available information at a certain point in time such as inflation
and real economy developments. One of the first tools employed to influence economic
variables is the main refunding rate as this is a benchmark rate in the economy. Though it may
not be sufficient for conducting monetary policy, the short term interest rate is in fact very
important. Traditionally, its level has influenced the opportunity cost of capital and the
availability of credit in the economy. In the context of financial innovation and deregulation,
one may argue whether this is the case today.
There is a significant amount of literature that analyzes monetary policy through the
lenses of main refinancing rates. One stream of such research is represented by “Taylor
rules”, a set of equations that determine the optimal level of main refinancing rates, taking
into account the inflation developments over some determined period and the level of
economic activity in comparison to a full capacity utilization level. Research in this area
suggests that under an optimal policy, nominal rates should rise sufficiently in response to
rises in expected inflation. In the set of equations taken into account, the coefficient on
inflation should be higher than one. Even if the framework is quite simple, it contains the
goals monetary policy can achieve. Taking into account price and output gap developments,
the policy analyzed characterizes what response the interest rates should have taking into
account a given state of the economy. From the perspective of such a framework, the results
are robust across most macroeconomic models. The issues explored in the thesis are:
Do the ECB and Bundesbank monetary policies follow a Taylor - type rule?
Are the monetary policies of the two central banks accommodating or stabilizing?
Is the monetary policy in the EU different under J.C.Trichet and W. Druisenberg
office?
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What form of the Taylor rule is followed by the ECB?
The thesis is organized as follows: chapter two will make a literature review of
monetary policy issues and a presentation of Taylor rules. Chapter three will present monetary
policy issues from a practical perspective and will make an introduction to the monetary
policy of the ECB and the Bundesbank. Even if the goal of monetary policy can be
straightforward in some cases, there are at least several issues that arise in practice: the
information available is also imperfect and there are lags until monetary policy is felt in real
economy, private sector does not have rational expectations and there are non-smooth
preferences over inflation and output and central bank interest rate smoothing. (R.Clarida,
J.Gali, M.Gertler, 1999). Another practical issue is that the target variables depend not only
on the current policy, but also on expectations of future policies. The future path of the
interest rates is important for the output gap and the future inflation rates for present inflation.
In such an environment, credibility arises as an important issue, as suggested by Kydand and
Prescott (1977). The next chapter is a preamble to the empirical part of the thesis, dealing
with sampling issues, the estimation methodology and the measurement of the variables
included in the dataset. Chapter five presents the empirical findings and answers the questions
above. The conclusions are drawn in the next chapter and the output from the econometric
software is presented in the annexes. The annexes will first present the data, the output gap
estimations and will continue with the output from the statistical software and the results of
the robustness analysis.
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Literature review:
2.1. Taylor Rules
After its presentation at Carnegie Rochester Conference on Public Policy in November
1992, the Taylor rule has received a great deal of attention both from the academia and from
the US policy makers. Its simple intuition was somewhat astonishing and the accuracy with
which it predicted the Fed’s funds rate brought a new understanding of monetary policy. The
main advantage of using such a rule is that it may give a rough estimation of where the funds
rate should be and it comes handy when dealing with macroeconomic models. The Taylor rule
addresses in a concise manner the dual objective of monetary policy in the USA, „to promote
maximum employment, production and purchasing power”. It links in a direct way the federal
funds rate to the monetary policy objectives: minimizing inflation fluctuations and addressing
the potential output achievement. This simple tool addresses pragmatically the objective of
monetary policy: minimization of the squared deviations of output and inflation from their
targets. It calls for a countercyclical response to demand shocks. The empirical work of
Taylor (1993) suggest that a rule that targets real output growth and the price level is
preferable to other alternatives taken into consideration. However, it is not clear from his
study the precise weight to be put on output, while finding that a rule that has some weight on
output performs better than a rule that targets only the price level.
There is quite a significant amount of different type of rules in the literature. These
rules target usually some the variables: deviations of the money supply from some target,
deviations of the exchange rate from target, weighted deviations of the inflation rate and real
output from some target. As empirical evidence suggests, the rules that focus on deviations of
the inflation rate and deviations of real output are the most useful for monetary policy and
have most predictive power at tracking the main refinancing rates. This is the case for US
data, as most of these studies are performed on American data. Taylor (1993) argues that such
policy rules cannot and should not be mechanically followed by policymakers, as the
underlying economic processes are more complicated and a degree of anticipation from the
part of the central bank is needed for an efficient monetary policy.
Since Taylor published its seminal paper (Taylor, John B., 1993) quite a significant
thought was accorded to this issue. Following the example of M. Friedman and A. Schwartz,
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Orphanides ( Orphanides A., 2002) has conducted a historical monetary policy analysis in the
USA though the perspective of the Taylor framework. Examining the Federal Reserve
policies over several periods, he found that it can be interpreted in the Taylor framework quite
consistently. Orphanides ( Orphanides A., 2002) also makes the difference between the real
time and retrospective usefulness of the Taylor rule. (Clarida R., Gali J.,Gertler M., 2000)
estimate a forward looking monetary policy reaction function for the United States data. Their
findings are consistent with those of Taylor (1993) as they assume a forward-looking behavior
on the part of the central bank. A forward looking approach is viewed by McCallum as more
appropriate for output gap stabilization (McCallum B.T., Nelson E., 1999). An insightful
forward looking model is presented in Batini and Haldane (Batini N., Haldane A.G., 1999).
Their study suggests among other very interesting conclusions, that the inclusion of an output
gap variable in a monetary policy rule improves output stabilization with no costs in terms of
inflation control, as long as the weights attached to output are not too big.
On the other hand, studies by Rotemberg and Woodford suggest that backward –
looking Taylor rules do not underperform forward – looking rules. Their crucial insight is that
there is no need for a forward - looking rule as long as the private sector is forward - looking
(Rotemberg J.J., Woodford M., 1999). Another proposal from their seminal paper is to model
the change in the target funds rate as a function of deviations of inflation from its target value.
This is confirmed by studies of Levin, Wieland and Williams (Levin A., Wieland V.,
Williams J.C., 1999). They also find that more complicated rules generate very small gains in
stabilizing output and inflation compared with first difference rules. Moreover, such rules are
more robust to model uncertainty. A backward looking rule is based on realized inflation
rates, whereas a forward looking rule has a forecast at its core. On the other hand, from the
perspective of the effects on the economy, a forward looking rule appears more appropriate.
There is in fact a tradeoff between choosing forward looking parameters to backward looking
information. Empirical evidence so far suggests that backward looking rules are more robust
and perform at least as well as forward looking rules.
Besides the precise specifications of a policy rule, one must understand the use of such
tools. As suggested by Svensson, the role of such explicit instrument rules is at best to provide
a baseline and comparison to the policy actually followed (Svensson L.E.O., Rudebush G.D.,
1999). The purpose of such rules is not to restrict central banks field of action, but mostly to
help the public evaluate ex post the effectiveness of the monetary policy. It also can be used
as a benchmark for assessing the current stance of the monetary policy. Furthermore, the
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rationale of having a greater oversight on the monetary policy is that, as Kydland and Prescott
(1977) suggest, discretionary policy for which the policymakers select the best action, given a
specific current situation, will not typically result in the social objective function being
maximized. They also argue that rules increase the central bank’s ability to precommit to
avoiding monetary surprises, which in turn permits a lower steady-state rate of inflation.
Having such a setting, having some rules at hand is quite useful. They also argue that it is
preferable to have simple rules that could be easily understood, so that it would be obvious
when a policymaker deviates from its mandate. (Barro R.J., Gordon D.B., 1983) also find that
discretionary policy may have unwanted results and that rules are preferred to discretion when
dealing with monetary policy.
Nowadays, many economists agree that optimal monetary policy involves that the
central bank will not try to exploit the short run tradeoff between unemployment and inflation,
because, as Lucas (1976) suggested, the private sector takes into account central banks
decision when forming expectations (Lucas R., 1976). Following the recent evidence on
different monetary policy rules, one can argue that such simple rules tend to be close to
optimal monetary policy rules, as they seem to track successfully the setting of main
refinancing rates. They also come to optimal rules as forms of such a rule are optimal for
central banks that have a quadratic loss function in deviations of inflation and output from
their respective targets, given a generic macroeconomic model with nominal price inertia
(E.O.Svensson, 1996) (Clarida R., Gali J.,Gertler M., 2000).
However, one critique to such a rule is that „it does not allow the monetary authorities
to respond to unforeseen circumstances” (Ben Bernanke, Rick Mishkin, 1992). While this is
true, the author acknowledged that”... there will be episodes where monetary policy will need
to be adjusted to deal with special factors”. The transcripts of the Federal Open Market
Committee show that Taylor rule was consulted systematically by different members of the
Fed during the 90’s. Researchers have been arguing that the rule proposed by Taylor to
describe the main refinancing rates expected level is too restrictive to have actual predictive
power. The reasons for such conclusions are diverse. Firstly, it is argued that the rule implies
that there is possible an immediate adjustment of the main refinancing rates to the target level,
which is not feasible in the context of interest rate smoothing practiced by central banks all
over the world. The second argument challenges the assumption that the central banks have
perfect control over interest rates and the third is that all the actions taken by the monetary
authorities are systematic responses to economic information and that there is no room for
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randomness in policy actions (Goodfriend, M., 1991) and (Clarida R., Gali J.,Gertler M.,
2000). These arguments can be challenged, of course.
One issue that arose with using the Taylor rule is the fact that it is not, in its original
form, a forward looking approach and therefore, it may not be suitable for monetary policy
decisions. Furthermore, the data needed in the model may not be available in the quarter the
fed funds rate is set. Another issues associated with this rule is whether the assumed interest
rate is the natural rate and whether the estimated output gap is the empirical one. Both of
these measures are highly dependent on different assumptions and the statistical methods
used. McCallum argued in 1993 that Taylor rule was not „operational”, as it required
information that was not available very fast to monetary authorities. ( Orphanides A., 2002)12
Real time measurement of the output gap is practically impossible with accuracy. The central
bank is unable to perfectly distinguish between cyclical movements in output and changes in
its trend component. The Taylor rule requires information that policy makers may not have at
their disposal when conducting monetary policy. The classic Taylor rule can be useful to
evaluate monetary policy ex – post, having a descriptive purpose while a forward - looking
rule is, by nature, normative in purpose. The table below presents an overview of the main
findings of research papers focused on Taylor rules on different data sets:
Table 1: Literature review on Taylor rule estimates
Authors
Sample
Sample Period
area
Estimated Parameters
α
β
γ
1979-1993
3.14
1.31
0,25
0,91
G. EMU
1990-1998
2,40
1,58
0,45
0,98
EMU
1980-1997
3.87
1,2
0,76
0,76
(Clarida R. Gertler Germany
M., 1996)
(S.Gerlach,
Schnabel, 1999)
(G.Peersman,
1
McCallum's original concern regarded the timing of information on inflation and the output gap.
Orphanides (2001, 2003) demonstrated that the informational problem was broader and quantitatively
severe in practice, especially regarding the measurement of the output gap."
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F.Smets, 2002)
(J.S.Mesonnier,
EMU
1973-2003
2,56
1,74
0,83
0,90
Gerlach- EMU
1988-2002
-1,23
2,73
1,44
0,88
Euro Area
1999-2002
2,60
0,45
0,30
0,72
Euro Area
1999-2002
2,96
0,25
0,63
0,19
J.P.Renne, 2004)
(P.
Kristen, 2003)
(D.Gerdesmeier,
B.Roffia, 2003)
(K. Ulrich, 2003)
Another aspect of the Taylor rule is that it somewhat failed to predict the federal funds
rate in the late 90’s until now in the USA. Before the financial crisis it would have predicted a
tighter monetary policy in the US. In the depth of the crisis many economists suggested that
the lax monetary policy in the USA was a major factor that contributed to the housing boom.
Thus, this fact links to the idea that the Taylor rule contributes to a more systematic and less
discretionary monetary policy. This is actually one of the advantages of such a rule:
controlling discretionary monetary policy and penalizing automatically deviations from
inflation targets and output fluctuations. This is a sensible argument, as on the long term,
monetary policy can only control variables such as inflation and the nominal exchange rate. It
cannot increase the average level or the growth rate of real variables such as GDP and
employment, or affect the average level of the real exchange rate. At best, it can reduce the
variability of real variables (Svensson, Lars E. O., 2002). On the other hand, those that do not
agree with the Taylor rule may suggest that this was relevant for the period initially taken into
account by Taylor and that the rule may not be valid anymore.
One criticism of simple interest rate rules is that, under certain circumstances, they may
induce instability. That is, in many models there may not be a determinate equilibrium under
particular parametrizations of the policy rule. In a classic paper, Thomas Sargent and Neil
Wallace, (Wallace, Thomas J. Sargent Neil, 1975) illustrated how nominal indeterminacy may
arise if prices are perfectly flexible. As Bernanke and Woodford (M. Woodford, B. Bernanke,
1997) emphasize, indeterminacy is also possible if the rule calls for an overly aggressive
response of interest rates to movements in expected inflation. In this instance, there is a
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"policy overkill" effect that emerges that may result in an oscillating equilibrium. They also
suggest that the central banks should not tie monetary policy to closely to any variable and
that there is a real need for developing structural models of the macro economy and using
multiple sources of data when deciding monetary policy.
An advantage of monetary policy rules as that suggested by Taylor (1993) is that simple
rules are more robust when there is uncertainty about the structure of the economy. They are
also preferable due to the fact that using such rules the central banks are on one hand, more
accountable for their actions, and on the other hand, more credible to the public. Being simple
and easy to monitor, such rules become most practical. The variables suggested by a Taylor
rule is useful to private agents in decision making as it is controllable by the central bank, can
be predicted if the bank has sufficient credibility and can be used as a leading indicator.
(Levin A., Wieland V., Williams J.C., 1999) suggest that more complicated rules perform
only slightly better than those with a simpler specification. Furthermore, studies suggest that
simple rules are more efficient and more robust than more complicated policy rules. This is
because complicated rules and optimal rules are fine-tuned to the particular details of models’
specifications. Simple policy rules appear effective in minimizing the fluctuations in inflation,
output and interest rates. As suggested by Taylor (1993) the rule is astonishing simple, so that
it can be put on the back of a business card:
Table 2: Monetary Policy Rule
% Deviation of Real GDP from Potential GDP
Inflation Rate
-2
0
2
0
0.5
1
2
2
3
4
5
4
6
7
8
6
9
10
11
8
12
13
14
(percent)
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While there is a significant literature that analyses the monetary policy in the United
States, the studies that focus on Euro Area data are at their infancy. One reason for this
situation is that there is only ten years of data for the single monetary policy in the euro area.
Such lack of long time series represents a certain inconvenient and puts under scrutiny the
validity of the studies. Moreover, out of sample studies are even more difficult to perform.
2.2. Inflation targeting
An inflation targeting regime is the delegation of monetary policy to a central bank
that is assigned an explicit inflation target, an implicit output or unemployment target, and an
implicit relative weight on output and unemployment stabilization. (Svensson, 1996).
Inflation targeting has known a great success among academia and the practitioners in the
1990s, as the intermediate targets for monetary policy have proven powerless in front of
financial innovation and international financial integration. In a short span of time, a number
of central banks have adopted inflation targets in their conduct of monetary policy. As M.
Friedman suggests, inflation targeting does not mean eschewing concern for real economic
outcomes and it does not imply that money is neutral in the short and medium term. In such a
context, inflation targeting seems to provide the rigor of a strong anchor, while allowing for
flexible behavior from the part of the central bank in the short term. Providing a strong anchor
to the economy is essential from the perspective of stability, as private sector agents can form
their expectations about the future taking into account the anchor. Volatile inflation rates
impair the market mechanisms to efficiently allocate resources and can lead in the future to
greater variability in inflation rates.
There is a tradeoff between the output gap variability and the inflation rate variability,
as suggested by Svensson in 1996. Gali, Clarida an Gertler (2000) argue that if the central
bank will try to push output above potential, then a suboptimal equilibrium would emerge and
there would be an inflation rate persistently above target without any gain in output.
Therefore, the central banks should abstain from such discretionary policies. The figure below
plots the tradeoff function. There is such a tradeoff if the inflation is driven by cost only. If
inflation is driven by consumption or demand side in general, there is no such tradeoff and the
central bank should fight off inflation right away.
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Graph. 1: The tradeoff between inflation rate variability and the output gap
variability
Output gap variability
Strict inflation
targeting
Flexible
inflation
targeting
Strict output gap targeting
Inflation Variability
From the empirical result one can conclude that the ECB monetary policy is
somewhere close to the middle point of the graph, having both an inflation target objective
and an output gap stabilization policy. The Bundesbank, however, is closer to the strict
inflation targeting point. Researchers point out that the tradeoff above can be improved by
increasing the central bank’s credibility. This point will be discussed later in the thesis.
There are several prerequisites for a country to be able to implement inflation
targeting: the existence of a well developed financial system that allows an efficient conduct
of monetary policy, a solid inflation forecasting framework, a healthy political system and a
independent central bank.
Inflation targeting is leading to a more transparent monetary policy and there is a
better communication of central bank’s intentions. As suggested by early research, (M.
Woodford, B. Bernanke, 1997) a desirable advantage of such a monetary policy is that the
inflation targeting central bank may avoid the „velocity instability problem”, which arises
when there are unexpected changes in the relationship between the intermediate target and the
ultimate objective.
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A clear disadvantage to inflation targeting monetary policy is the lagged empirical
observation of inflation. The lack of timely information will force authorities to conduct their
analyses through forecasted values of such variables. One way the central bank can overcome
this problem is by having a medium term inflation objective and allowing for small temporary
deviations from the assumed target. Researches warn, however, that a zero rate of inflation
imposes permanent real cost on the economy rather than providing the benefits of low
inflation (Akerlof G., Dickens W., Perry G, 1996). Such costs seem to be more bearable by
the public, as inflation costs appear in the eyes of the public higher than the costs of
undergone employment and output. The reason for such an attitude is still unclear: the risk to
loose the existent social order or that inflation hurts most lower (and more numerous) classes.
An important issue with inflation targeting that is not discussed in the literature is the
source of inflation. As Clarida, Gali and Gertler suggest in their seminal paper (R. Clarida, J.
Gali, M.Gertler, 1999), one of the big challenges a central bank face is to distinguish the
source of inflation and to anticipate the effects of an inflationary shock. They suggest that an
optimal monetary policy should on one hand adjust the interest rate to offset demand shocks
and on the other hand accommodate shocks to potential output by keeping the nominal rate
constant. The Federal Reserve has encountered such an issue in the 90 s, and most economists
agree today that the federal funds rate was kept too low for too long.
There are several advantages to inflation targeting in comparison to other variables
targeting. With a specified quantitative target, a central bank becomes more accountable of its
monetary policy. If the central bank strictly follows the assumed target, it manages to create
credibility in the markets and anchors inflation expectations. A low inflation target can reduce
or eliminate the inflation bias. However, central banks have no perfect control over inflation.
There are many sources price movements and today’s inflation is the result of past decisions.
Svensson argues that efficient inflation targeting is based on central bank’s inflation forecast
for a future period rather than today’s inflation (Svensson, 1996). He argues that inflation
forecast targeting would provide a simpler implementation and monitoring of monetary
policy. The weight on output stabilization must determine the speed with which the inflation
forecast is adjusted towards the inflation target. This solution is considered superior to money
growth or exchange rate targeting as it leads to lower inflation variability.
Other researchers suggest that inflation targeting should appear as a general
framework rather than a policy rule. Thus, increased transparency and coherence of policy
would be possible, while keeping possible flexible monetary policy actions (F.Mishkin, Ben
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S. Bernanke , 1997). An inflation targeting regime does not necessarily mean inflexibility
towards short run stabilization needs. The accommodation of short run stabilization needs is
compatible with inflation targeting as in most cases, this goal is to be achieved in the medium
or in the long run. Friedman and Kuttner view inflation targeting following a Taylor rule
amounts as a well defined monetary policy strategy while making the point that such policy
may be a too rigid monetary policy (Friedman B. M., Kuttner K.N., 1996). However,
(Svensson L.E.O., 1995) finds that no central bank with an explicit inflation target seems to
behave as if it wishes to achieve the target at all cost, regardless of output and employment
consequences. Their evidence suggests that the optimal inflation target should not be zero,
even if such a target may help from a fiscal point of view.
Much of the modern research on central banking is focused on the incentives system the
central banks face when conducting monetary policy. Studies suggest that discretionary
monetary policy leads to some extent to a higher average inflationary bias. Institutional
structures and differences may act as incentives for central bankers. More independent central
banks have been historically associated with lower inflation rates.
A monetary policy rule should be based on variables that can be controlled with high
frequency by the central banks and that require information that can be collected and
processed by monetary authorities. One such candidate variable is the main refinancing rate
that is set by the central bank. Such a rate plays a significant role in the economy and it can be
used by the central bank for conducting monetary policy. The interest rate channel is proved
to be important in the transmission mechanism of the monetary policy. It has two ways of
affecting the economy. One, by working through the output gap and into inflation and the
second, less direct, through the exchange rate, with direct price effects into the cost of
imported goods and then through wages and then output prices. Bernanke and Blinder show
that the interest rate on the Federal funds is very informative on future movements of real
macroeconomic variables (Bernanke B.S, Blinder A.S, 1992). This only reflects its relevance
in conducting monetary policy. As they study suggests, the main refinancing rate is superior
to M1 M2 or the Treasury rate in predicting macroeconomic variables. In fact, this is what
happened with the conduct of monetary policy in the US: as the M1, M2 and M3 variables
lost their particular relevance for monetary policy, the main refinancing rate has been
employed as the main monetary policy instrument. It is believed that this is instrument is
more useful than targeting an intermediate money aggregate. Experiences in the USA in the
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’70 have proved that a monetary policy that targets such aggregates as M3 may be too lax and
lead to inflation build up.
2.3. Interest rate smoothing
Historically, the actual interest rate displays much less volatility than the optimal
interest rate. Central banks engage in interest rate smoothing, taking cautious small steps
when changing interest rates. There are at least two reasons for such a conduct. Such action is
desirable to the extent the central bank cares about avoiding excessive volatility in the short
term interest rate in pursuing its stabilization goals. The second argument is that the central
bank is revising permanently its assessments about the economy, as new information comes to
its knowledge. Even in the case of a nondiscretionary monetary policy, interest rate smoothing
is consistent with the assumed policy rule. This is possible in the presence of parameter
uncertainty. The central bank will take cautious steps in changing the monetary policy tool,
thus acknowledging the uncertainty of its estimations about the real economy and inflation. In
such a setting, some degree of interest rate smoothing can be regarded as appropriate. Interest
rate smoothing must be viewed in the context of central bank’s role of maintaining stability.
Smooth changes in the short-term interest rate provide control over long-term interest rates
and thereby over aggregate demand and inflation at low cost in terms of funds rate volatility.
Goodfriend (1991) finds some interesting arguments in favor of interest rate smoothing. He
argues that for a given movement in the short-term interest rate, the impact on long-term
interest rates is greater if the movement is expected to be sustained rather than short-lived. In
such a setting, interest rate smoothing offers the potential for greater control over long-term
bond rates and hence over aggregate demand and inflation for a central bank. (Goodfriend,
M., 1991). Disagreement among the decision factors inside a central bank may provide a
reason for interest rate smoothing as well as some reluctance on the part of the central bank to
put additional strain on the financial sector, especially on commercial banks. High
unanticipated movement in the interest rates can lead to high financial losses and as the
supervisor of the banking sector, the central bank is somewhat colluding with the ones it is
suppose to supervise. These arguments have not been tested too much in practice, so the
evidence is somewhat anecdotic rather than empirically tested.
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Practical issues
There are also several practical issues when implementing monetary policy. The most
obvious one is the imperfect information available to central bankers. At the time of interest
rate setting, the central bank does not have all the necessary data available and the data
available is most of the time of a lagging character. There are some data that are not
observable, as the natural level of output that are measured with great error. Svensson (1997)
has emphasized the practical importance of the mechanics of inflation targeting. He suggested
that focusing on the inflation forecast can be a practical solution when judging the course of
monetary policy. Even after taking a decision, the central bank cannot fully control the path of
a target variable. As proven in the USA during the Great Depression, failure of a central bank
to take preemptive action as soon as there are signals of a slowdown can lead to very costly
phenomena in the economy. Another issue with the conduct of monetary policy is that the
mechanisms by which central bank actions affect the nonfinancial economy mostly involve
lags often measured in years rather than weeks or months. Many important aspects of the
economic circumstances in which the central bank’s actions will be having their effect are,
therefore, not just unknown but unknowable when the decisions governing these actions are
taken. When conducting monetary policy, a central bank has at least several issues to look at:
it must understand how the markets will react to the decisions taken, how the aggregate
demand react to changes in the transmission variables, how the unemployment rate will be
affected and how the Phillips curve will react. These are just some of the variables a central
bank must take into account when deciding whether to change the funds rate.
2.5. Credibility
Another issue with monetary policy and the policy design is credibility in central bank’s
actions. Private actors have a close look on present monetary policy and they try to guess the
future stance of monetary policy. Batini and Haldane find also that the greater forward lookingness on the part of the private sector, the less the compensating need for forward –
lookingness by the central bank The credibility of monetary policy becomes an important
issue, as studies suggest. ( Goodfriend M., King R.G., 1997). Since the pioneering works of)
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(Kydland F.E., Prescott E.C, 1977), Robert Barro and David Gordon (1983), and Rogoff
(1985), the credibility of monetary policy has been viewed as essential to the conduct of
monetary policy. It reaches the problem of persistent inflation under discretionary monetary
policy as the central bank tries to push the economy above its natural level. What is suggested
is that if there is a credible central bank, fighting inflationary pressures becomes easier than
otherwise, as private agents’ expectations incorporate lower inflation. Thus, wages and prices
do not move as fast upwards, due to lower inflation expectations. Other research suggests that
there are gains from credibility even when the central bank is not trying to push output above
its natural level (R. Clarida, J. Gali, M.Gertler, 1999). Credibility is found in other studies to
important from other reasons. There appears to be a significant degree of stabilization without
a great deal of interest rate volatility in the cases where the central bank is committed to the
monetary policy rule and the private sector is confident that this policy will continue in the
future (Rotemberg J.J., Woodford M., 1999). A significant contribution in the literature was
made by K.Rogoff (1985), as he suggested the delegation of monetary policy to a
conservative central bank that is putting more weight on inflation stabilization than the society
does, as such action would reduce the inflation bias. His findings were challenged by
(Svensson L.E.O., 1995) who demonstrates that an inflation targeting regime can achieve the
second best equilibrium and that it is better to delegate monetary policy to a central bank with
a low inflation target, that to a conservative central bank, as Rogoff suggested. Inflation
targeting appears, from a practical point of view, much easier to implement. Credibility is
important when anchoring public’s inflation expectations. For the monetary policy to have a
greater effect in the short run, the inflation rate should be unexpected, so that the short run
Phillips curve flattens. Such a result is to be expected only if the public believes that the
central bank will come back to its target soon enough. That is why credibility is essential in
order the monetary policy to have any effect in the short run. When analyzing monetary
policy of a central bank that is credible, one may see in fact that there is actually no conflict
between discretion and monetary policy rules in such a setting.
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3.
ECB’s vs. Bundesbank’s monetary policy
3.1.
Organization of the ECB
The European System of Central Banks (ESCB) is functioning in accordance with the
Maastricht Treaty. The European System of Central Banks (ESCB) is governed by the
decision-making bodies of the European Central Bank. The Governing Council of the ECB
formulates the monetary policy and the Executive Board implements monetary policy
according to the decisions and guidelines set by the Governing Council. The ESCB has
recourse to the national central banks for carrying out the operations which form part of the
tasks of the Eurosystem. The national central banks may, if necessary for the implementation
of monetary policy, share amongst the Eurosystem member individual information, such as
operational data, related to counterparties participating in Eurosystem operations. The
Eurosystem’s monetary policy operations are executed under uniform terms and conditions in
all Member States.
3.2. Tools of the ECB:
In order to achieve its objectives, the Eurosystem has at its disposal a set of monetary
policy instruments: it conducts open market operations, offers standing facilities and requires
credit institutions to hold minimum reserves on accounts with the Eurosystem. In the open
market operations, the most important instrument is the reverse transaction (applicable on the
basis of repurchase agreements or collateralized loans). The other operations are outright
transactions, the issuance of debt certificates, foreign exchange swaps and the collection of
fixed-term deposits. Open market operations are initiated by the ECB, which also decides on
the instrument to be used and on the terms and conditions for its execution. Open market
operations are used for steering interest rates, liquidity management and signaling the stance
of monetary policy. The Eurosystem’s minimum reserve system applies to credit institutions
in the euro area and primarily pursues the aims of stabilizing money market interest rates and
creating (or enlarging) a structural liquidity shortage. All the operations conducted by the
ECB must be based on adequate collateral. The marginal lending facility can be used to obtain
overnight liquidity from national central banks at pre-specified interest rates against eligible
assets. The facility is intended to satisfy counterparties’ temporary liquidity needs. Under
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normal circumstances, the interest rate on the facility provides a ceiling for the overnight
market interest rate. The terms and conditions of the facility are identical throughout the euro
area.
The main refinancing rate is essential to monetary policy today, as past experiences in
other central banks has proved that following other targets, like the money growth can provide
erroneous information. Thus, the main refinancing rate has slowly become the main
instrument for conducting monetary policy and it is, as for today, a very relevant piece of
information to the markets when it is announced. The main interest rate is essential, as it is a
part of the transmission mechanism of the monetary policy, it is a basic input when
determining the cost of capital and it is the most important factor at determining exchange
rates in a floating regime.
3.3.
Independence:
In accordance with Article 107 of the treaty, the ECB and the banks members of the
ESCB are independent and they should not “seek or take instructions from Community
institutions or bodies, from any government of a Member State or from any other body. The
Community institutions and bodies and the governments of the Member States undertake to
respect this principle and not to seek to influence the members of the decision-making bodies
of the ECB or of the national central banks in the performance of their tasks. When exercising
the powers and carrying out the tasks and duties conferred upon them, neither the ECB nor the
NCBs, nor any member of their decision-making bodies, are allowed to seek or take
instructions from Community institutions or bodies, from any government of a Member State
or from any other body”. The central bank is established as an independent body and it is at
this moment one of the most independent central banks in the world. It also conducts the
monetary policy for the euro area. This is quite a challenging task as the euro area is not
unified from the fiscal point of view and there is a great deal of diversity between the
countries within it. There are not only great fiscal differences between these countries, but
quite different growth rates, inflationary pressures and other underlying macroeconomic
variables. Independence of the central bank is a highly valuable attribute, as empirical studies
showed that more independent central banks, where they are so from a legal or de facto point
of view, tend to have average lower rates of inflation.
3.4. Monetary policy objectives of the ECB
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The mandate of the European Central Bank is established in the Maastricht Treaty. In
accordance with Article 105(1) of the Maastricht Treaty, “the primary objective of the ESCB
shall be to maintain price stability. Without prejudice to the objective of price stability, it shall
support the general economic policies in the Community with a view to contributing to the
achievement of the objectives of the Community … The ESCB shall act in accordance with
the principle of an open market economy with free competition, favoring an efficient
allocation of resources”. The Treaty also establishes the tasks that are to be carried out
through the ESCB:
“- to define and implement the monetary policy of the Community;
- To conduct foreign exchange operations consistent
- To hold and manage the official foreign reserves of the Member States;
- to promote smooth operation of the payment systems”
The ECB has the exclusive right to authorize the issue of banknotes in the euro area. It
also collects statistical data together with the National Central Banks in order to perform the
necessary analyses for conducting monetary policy in the euro area.
In comparison with the Federal Reserve, the European Central Bank has a
straightforward objective of price stability. It aims at inflation rates below, but close to two
percent, over the medium term. "Without prejudice to the objective of price stability", the
Eurosystem will also "support the general economic policies in the Community with a view to
contributing to the achievement of the objectives of the Community". These include a "high
level of employment" and "sustainable and non-inflationary growth".3 There is a clear
hierarchy of objectives for the Eurosystem established in the treaty. Price stability is the
overriding principle and it is thought that by achieving price stability the central bank will be
able to pursue a monetary policy capable of sustaining a favorable economic environment and
a high level of employment. In such manner the ECB is to create the environment for
increasing economic welfare and the growth potential of the economy. The Treaty provisions
also imply that, in the actual implementation of monetary policy decisions aimed at
maintaining price stability, the Eurosystem should also take into account the broader
economic goals of the Community. In particular, given that monetary policy can affect real
activity in the shorter term, the ECB typically should avoid generating excessive fluctuations
in output and employment if this is in line with the pursuit of its primary objective. The
specific target set to the ECB made it more accountable for the price developments in the euro
3
Treaty on the Functioning of the European Union, Article 127 (1)
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area. Increased accountability and the creation of a stable inflation framework are two
important arguments for inflation targeting. During the crisis, the ECB lowered its main rate,
as a consequence of lower inflation expectations in the short and middle term. Such actions
can provide some boost to the economy while still keeping monetary authorities accountable.
In ECB’s view, price stability is a „year-on-year increase in the Harmonized Index of
Consumer Prices (HICP) for the euro area of below 2%”, as defined by the Governing
Council. The time frame taken into account is the medium term.
The Governing Council bases its decisions on both economic dynamics and shocks
and on monetary developments in the euro area. In this way, the Council aims to have a full
set of information in order to conduct monetary policy. Price stability targeting is seen as an
advantageous approach to monetary policy, as it

“Can improve the transparency of the price mechanism. This is relevant for
consumers as it may allow them to make informed decisions when allocating
resources;

Reduces inflation risk premia in interest rates. In this way it may lead to
lowering the cost of capital for enterprises.

Limits unnecessary hedging activities;

Reduces distortions created by large price movements (inflation or deflation),
thus reducing the impact on economic behavior of tax and social security systems;

Limits an arbitrary redistribution of wealth and income as a result of
unexpected inflation or deflation.”
One of the reasons why the bank is having a close watch over the inflation is the
broadly shared opinion that inflation is basically a monetary phenomenon, as suggested by
Milton Friedman. There is also an understanding of what a central bank can do in the short
and in the long run. While recognizing the influence its policy may have in the short run over
growth rates in the euro area, ECB chooses not to intervene at this level. In the long run the
central bank can only contribute to raising the growth potential of the economy by
maintaining an environment of stable prices. For a long span of time, the only variables ECB
can influence are the inflation rate and the nominal exchange rate. Any short term action that
would favor output growth to the expense of rising prices is regarded as unsustainable. This is
in contrast with monetary policy conducted in the USA, where there is a clear concern in
regards to growth and unemployment. However, no central bank in the world can target
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directly and fix the unemployment rate to a wanted level without any impact on inflation.
Therefore, there always exists a tradeoff between the inflation on one side and economic
growth and unemployment on the other side. Inflation is a perilous phenomenon in an
economy as it reduces the buying power of all the people. Therefore, one may regard the
effectiveness of the central bank’s activity through the view of prices. In the presence of high
inflationary pressures, there has always been an instable environment, from the social,
political and economic point of view. This is one of the reasons why inflation targeting is seen
as a primary objective in many countries in the world, no matter whether there is an explicit
target figure. Example of such countries is Sweden, Finland, Australia, The United Kingdom,
New Zealand and Canada. In other inflation targeting countries, inflation forecasts are less
explicit but nevertheless a fundamental part of the monetary policy process. Germany always
had an implicit inflation target as a point for a one-year horizon. In contrast, the ECB has a
midle and long term view over inflation developments and the target is
2%. There is a good
rationale to consider inflation targeting in the middle and long term, as most economist agree
that monetary policy can affect real quantities only in the short run. In the long run, only the
inflation rate can be controlled by central banks. The use of bands rather than point estimates
around a specific inflation target allows monetary authorities to adjust monetary policy to
external shocks (like the oil price hikes in the 70s).
Moreover, a central bank must pursuit some short term goals without losing sight of
the long run target. Shortsighted decisions may lead to disastrous results in the long term. Any
reduction of the marginal interest rate has an immediate impact on the yields, but it also has a
longer term impact, through the transmission mechanism of the monetary policy. An initial
impulse generates a series of effects thought the economy and the most perverse thing about it
is that its impact is almost impossible to estimate by economists ex ante and ex post. By
lowering the yields, the central bank in fact leaves more money available to banks. The
commercial banks, in their pursuit of profits will increase the credit available to the economy
and henceforth the total quantity of money available through the money multiplier effect. An
increase in the quantity of money will increase spending and will raise incomes. With higher
credit and consumption, the prices will rise in about a year after the first central bank
relaxation of the monetary policy. The magnitude of such a multiplier mechanism was
estimated for the USA to be about 7. However, such time series are not stationary and the
money multiplier changes from decade to decade. Monetary policy is very challenging as
there are many factors whose „natural” value may change over time: the growth of GDP, the
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natural unemployment rate, the speed of money circulation, etc. If one would choose
unemployment as the main goal of monetary policy, one would soon realize that such a target
is unfeasible; as the only variable the central bank can control in the long run is the inflation
rate. If the central bank has a target of, let’s say 4% unemployment, its actions would stabilize
the unemployment around the 4% target. This is not recommended, as any economy is under
continuous pressures from different shocks, both positive and negative. For example, the
development of information technology and of the Internet changed significantly the natural
rate of unemployment, both in the US and abroad. If the Fed would pursue the 4% target of
unemployment rate, it would only go against the economic reality.
3.5. The monetary policy of the Bundesbank:
The monetary policy in Germany has been of great interest. In the post war period
Germany had consistently lower inflation rates than any of other countries in the OECD.
Taking into account such a performance, the Bundesbank was the most cited example on
fighting inflation.
As in the case of the European Central Bank, in Germany inflation targeting is an over
ridding principle. Beginning from 1974 the Bundesbank set an inflation target for its
monetary policy without understanding the target as a strict point to be achieved. The
rationale for this is that a low inflation policy would provide an efficient shelter against costly
deflationary processes. While the monetary policies of the Bundesbank and that of the
European Central Bank are not fully comparable, the goal of the analysis is to find out
whether the ECB has followed Bundesbank’s monetary policy approach and whether it is as
attached to inflation targeting as its predecessor was. The paper will not make a full
description of the organizational and institutional issues of the Bundesbank, as it seems
irrelevant to this point. The interest is in comparing the monetary policies of the ECB to that
of Bundesbank.
In order to achieve the goal, the Bundesbank is aggressive at managing short term
interest rates. However, evidence suggest that in the case of Bundesbank, the process of
fighting inflation is not a costless one, despite the firm attachment to inflation targeting. In
order to reduce the costs associated with inflation targeting, the banks has a gradualist
approach in reducing inflation. Even after the oil shocks, the Bundesbank did no reduce
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sharply the interest rate. It did it in a more gradual manner. Further evidence suggest that the
Bundesbank reacts asymmetrically to the inflation gap: it tightens more aggressively the
monetary policy when inflation is above target and eases when it is below target. The inflation
targeting regime put in place did not impede the Bundesbank to take actions that take account
of the growth in the real sector.
4.
Sample selection, variables measurement and estimation methodology
4.1. Data
The data for the series come from the IMF, the ECB and Eurostat. The interest
rates are provided by ECB’s site. The GDP data is expressed in current prices. The
denomination is the euro. For Germany, the original figures provided by the IMF came in
USD, therefore we proceeded to euro conversion using the rate available on 4 th of January
1999, that of 1 EUR = 1,1789 USD. One should be aware that the data for the EU is limited to
10 years. This is one of the reasons why the German data is tested using the same technique.
In fact, the lack of longer observations for the euro area series represents one of limitations of
this study. The data is collected quarterly, both for German and Euro Area series. One first
step in preparing the data was to take the log of the real GDP series, to test for stationarity and
to address this issue by taking the first difference (
).
The German time series stops in 1999, as with the third stage of economic and
monetary union, monetary policy was transferred from the Deutsche Bundesbank to the
European Central Bank. From this perspective, a European view is more appropriate.
However, the connection between the Bundesbank’s monetary policy and that of ECB can
provide new insights, as Germany has probably the longest tradition of inflation targeting
monetary policy. A second limitation of the data is that this study did not have full access to
the ECB estimates of macroeconomic variables. As such the monetary policy review in a
Taylor rule framework may lack the internal ECB data. The sample period must contain
sufficient variation in inflation and output and must be sufficiently long in order to identify
the slope coefficients in the policy reaction function, as well as the target inflation rate p.
While this condition is certainly met in the German sample, the euro area series is shorter and
therefore there is only a business cycle that is grasped by the data.
The study uses the average of each quarter’s month marginal lending facility rate at
ECB (int), expressed in annual rates as the interest rate variable in equation 1. The
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productivity data series are expressed in percent on a quarterly frequency. This series and the
M3 growth data come from the ECB statistical warehouse. All the series come already
seasonally adjusted. The inflation rate is an average of the previous annualizes four quarters
of HICP (p). The various output gap measures considered are denoted in the data set as OG1,
OG 2 and OG3. The variables set includes also first order differenced series of inflation rate
(dp), interest rate (dinterest_rate) and output gap (doutput_gap, doutputgap02). Different
output gap measures are taken into consideration in order to test the robustness of our results.
A descriptive view of the data is presented below:
Table 2: Euro Area data summary:
Table 3: German data summary:
4.2. Variables measurement
4.2.1. Real GDP
In order to compute the real GDP, a GDP deflator is used. The data comes from the
Eurostat, and implicit deflators are calculated by dividing the aggregate measured in current
prices by the same aggregate measured in constant prices. The deflator is calculated from
seasonally adjusted GDP values. One simple way to get the GDP deflator is using the
formula:
GDP Deflator =
* 100
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4.2.2. Inflation rate
The target rate of inflation is another subject of debate in the business cycle literature.
It appears normal to try to relate inflation with the interest rate, as there is always empirically
a statistically significant relationship between these two variables. Furthermore, in the long
run, the inflation rate is probably the only variable central banks can influence. While most
economists acknowledge that a high inflation rate is damaging to the economy, none of them
can provide a clear figure that can be reliably used. It has been argued that an inflation rate
between 1 to 3 percent would meet the price stability definition (F.Mishkin, Ben S. Bernanke ,
1997). Taylor assumes a 2% inflation rate in its original paper. The inflation measure used in
the Taylor set of equations is the average of the last four quarters of the HICP. The evolution
of inflation rate is presented in the graphs below:
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4.2.3. Output gap
The output gap is the difference between actual and potential GDP. It is an important
measure that is used to assess the economic development and outlook. One would assess the
output gap by comparing the output in the economy in one period to the level of output that is
consistent with the full utilization of the factors of production in an economy in a stable
inflation environment. It is consistent with the output level that would be available in the
absence of price and wage stickiness. One should understand that the level of potential output
is largely independent of monetary policy. At best, monetary authorities can provide a stable
environment for the real economy. This does not mean, of course, that increasing potential
output is impossible. Structural policies can improve the economic environment, market
structures and functioning and all these can lead in the end to a greater potential output.
However, it is not possible to do so through the means of monetary policy.
Potential output is estimated using statistical methods and this leads to a high degree
of uncertainty. Usually one would estimate its level by looking at a growth trend of an
economy for a long period. For example:
Gap =
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Where GAPi is the output gap,
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is the GDP in real terms and
is the potential output of
the economy in the same period. One good approach to determining the output gap is to test
data using several methods and then take the averages of the outcome. However, as in the
case of any model, there could appear model specification errors. A thorough discussion of
output gap use for monetary policy and its drawbacks is presented in Orphanides (Athanasios,
Orphanides, 2002).
“The quantification of potential output—and the accompanying measure of the ‘gap’
between actual and potential—is at best an uncertain estimate and not a firm, precise measure
(Arthur M. Okun, 1962)”. As observed by Okun, the output gap is a highly uncertain variable
and there is no perfect tool for its measurement. It is, however, a good indicator of the slack of
an economy and an indicator of the cyclical position. A first definition of the output gap is
given by Okun (1962): the maximum output that the economy can produce under conditions
of full employment. As it represents the difference between the actual and potential output of
an economy, the output gap is calculated frequently by using various econometric methods.
However, none of them seems to give “the best” estimate and its value maybe more reliably
estimated using some bands rather than point estimates.
As the output gap is an unobserved variable, a number of statistical and economic
approaches exist in the literature for its estimation. Some of these include extracting the trend
out of the GDP data through various methods, using production functions or using some
underlying economic model. The basic methodologies of estimating the output gap can be
separated in two categories: statistical detrending and estimation of structural relationships.
One useful statistical detrending tool to assess the output gap is the Hodrick – Prescott
filter. Several empirical studies have proved that linear trends and Hodrick – Prescott filter are
quite reliable when computing the output gap. One advantage to using the HP filter is that it
can be applied to non - stationary time series. This filter is a mathematical tool used in
macroeconomics and in the business cycle theory to extract the cyclical component of a time
series. Let
for t = 1, 2, 3, T denote the logarithms of a time series variable. The series
is
made up of a trend component, denoted by ‫ זּ‬and a cyclical component, denoted by c such
that the logarithm of the time series variable are composed by the trend and the cyclical
component:
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One would then extract the trend component, given the formula:
Min
The first term of the equation is the sum of the squared deviations dt = yt − τt which penalizes
the cyclical component. The second term is a multiple λ of the sum of the squares of the trend
component's second differences. This second term penalizes variations in the growth rate of
the trend component. The larger the value of λ, the higher is the penalty. Hodrick and Prescott
advise that, for quarterly data, a value of λ = 1600 is reasonable. In the analysis of the data the
values chosen for the alpha term is 1600 and 129600. One should be wary to the drawbacks of
HP filters: possible spurious cyclicality with integrated series and excessive smoothing of
structural breaks. The graph below presents the magnitude in percent of the output gap and
inflation in the EU in the period considered and in Germany:
Fig.4: CPI inflation and output gap in the Euro Area in percentages
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Fig.5: CPI inflation and output gap in Germany in percentages
After being able to compute the potential output in this way, we could proceed to the
first output gap estimation. The output gap is, as defined above, the difference between actual
and potential output:
When the calculation yields a positive number, there is an inflationary gap in the
economy and this indicates that the growth of the aggregate demand is higher than the growth
of the aggregate supply, this may lead to higher inflation. When the number is negative, one
would call it a recessionary gap and this may lead to future deflation. In the euro area data,
about 50 % of the time there is an inflationary gap and about 50% of the time there is a
deflationary gap. The graphs below present the different output gap measures used:
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Fig. 6: Alternative measures of output gap in the Euro Area (1999-2009)
Fig.7: Alternative measures of output gap in Germany (1960 - 1998)
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The third output gap measure considered was constructed by using a smoothed series
of the real GDP data. The smoothing technique suggested by Holt - Winters has the advantage
of being quite simple to put into practice, while providing competitive results in comparison
to other models. The standard Holt additive method is described by the expressions:
where
is the actual observation,
is the m-step-ahead forecast, and and
are
smoothing parameters.
The output gap measures estimated using the HP filter with different λ and the Holt
smoothing do not present significant differences in the respect of the turning points of the
output gap. However, there is a difference of level between the three estimates and this would
reflect directly in the hypothetical main refinancing rate estimated using the Taylor rule. The
graphs above testimony the major problem of Taylor rate estimation: the output gap. Being a
non directly observable measure, the estimation of the output gap is an important task of any
central bank, no matter whether a Taylor type of rule is used. The stance of the monetary
policy in general depends on the output gap estimation by the central bank.
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The time series of the log of the real GDP were filtered also using Baxter King and the
Christiano Fitzegarld filters. The band pass filters are used to isolate particular components of
time series that are in a particular band of frequencies. The Baxter King filter is designed to
pass through components of time series with fluctuations between 6 and 32 quarters while
removing higher and lower frequencies. If applied to quarterly data, like in our case, the filter
takes the form of a 24 quarter moving average:
4.3. Estimation methodology
In our model, the instrument for conducting monetary policy is the main refinancing
rate. The empirical part of the thesis will analyze the monetary policy of the European Central
Bank and that of the Bundesbank following the framework introduced by (Taylor, John B.,
1993). According to Taylor “good policy rules call for changes in the federal funds rate in
response to changes in the price level or in real income”. He proposes a hypothetical but
representative policy rule that should determine the level of the interest rate set by the central
bank. The target rate in each period is a function of the output gap in the economy and the
inflation rate.
The rule suggested by Taylor takes the next form:
(1)
A more general rule inspired by Taylor:
R=
(2)
R=
(3)
where,
R
is the main refinancing rate
is the intercept term
p
is the average rate of inflation of the previous four quarters
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y
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is the percent deviation of real GDP from a target
is the responsiveness of policy to inflation
is the responsiveness of policy to output gap
L(r)
is the first lag of the interest rate
And
, where Y is the real GDP and
is the trend real in GDP
In this equation, the interest rates will rise when the inflation rate is rising and in the
case of perfect alignment of inflation rate and of zero output gap, the rate will be 4% or 2% in
real terms. The
term is to note that in the absence of any output gap and when the (p-2) term
is equal to zero, the interest rate is equal to the policy target. The main refinancing rate raises
most when the economy is overheating and inflation is peaking up. The inflation rate and the
output gap have equal weighting in the Taylor formulation, though the author recognizes in a
latter paper that a bigger weight on inflation is feasible. As equation 1 suggests, the response
of the interest rate depends on the coefficients
sign and value. If
is bigger than one, the
macroeconomics policies will tend to be characterized as strict inflation targeting regimes and
if
, there is a genuine concern for output deviations and the monetary policy is more
accommodative in nature.
There are several econometric issues we need to approach. First, one must test whether
the data is stationary and this is a very strong condition when dealing with time series data.
There are several tests that test time series stationarity. These tests are based on the following
set-up. Let
The null and alternative hypotheses are
H0 : φ = 1 (φ(z)=0 has a unit root)
H1 : |φ| < 1 (φ(z) = 0 has root outside unit circle)
The most well known tests are: Dickey – Fuller test, Augmented Dickey – Fuller test,
Phillips Perron test and Kwiatkowski – Phillips – Schmidt – Shin test (Favero C.A. , 2001).
The ADF and PP tests differ mainly in how they treat serial correlation in the test regressions.
To test for stationarity, the Dickey – Fuller test was conducted. The time series of inflation
rate, output gap and interest rate are not stationary, but they become stationary when the first
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difference is taken. This is valid both for the Euro Area and for the German data. The results
are presented in Annex 1.
The second issue is connected with the sample data. In order to achieve reliable results,
there should be sufficient variability in the data and the series must be sufficiently long in
order to identify the slope coefficients in the policy reaction function. The data for the
German monetary policy definitely grasps several business cycles and quite great variations in
output and inflation rates, so that we can reliably trust the result. For the Euro Area one
cannot have the same degree of confidence, as one business cycle is encompassed. However,
one does not have any other alternative and proceeds with the ten years of common monetary
policy available. This sample contains, however, important variation in inflation and output
gap developments.
In order to have a clear view on how various techniques of estimation affect the
conclusions drawn from the sample, the equations are tested using OLS and GMM. In fact,
OLS can be seen as a special case of GMM. Since L. Hansen presented it for the first time in
1982, GMM has become very popular among researchers in economics. The main advantage
of GMM is that it provides consistent result in presence of heteroskedasticity, though it
presents poor finite sample performance. GMM has been the standard estimation procedure
for Taylor rules since Gali, Clarida and Gertler’s paper in 2000.
The annexes present the output from the statistical software. This includes an analysis
of the regressions from the different techniques employed. From the methods employed, the
GMM stands best and is passing correctly the test performed. The results found by using
GMM are reliable. The OLS estimates cannot be trusted as different tests employed show the
violation of OLS assumptions.
After estimating using OLS and GMM, we proceeded with a VAR structure, in order
to see the relationships between the variables considered. A VAR system would better reveal
the dynamics between the variables considered.
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Empirical evidence
This section reports the estimates of the policy reaction function presented in equation 1.
Tables 4 and 5 present GMM estimates of the equation 3 parameters:
Table 4: Estimated Policy Rules for Euro Area data
Output Gap
α
β
γ
L
HP λ=1600
0,006685
-0,00219
0,148136
1,096052
(0,00019)
(0,00158)
(0,00414)
(0.00677)
0,01718
-0,00232
0,34866
0,358242
(0,00026)
(0,00010)
(0,00285)
(0,01190)
0,01158
-0,001993
0,136663
0,791055
(0,00046)
(0,00001)
0,004896
(0,01254)
HP λ=129600
Quadratic trend
0.777289
0,891375
0,877580
Table 5: Estimated Policy Rules for German data(1960 - 1998)
Output Gap
α
β
γ
L
HP λ=1600
0,001845
-0,060700
-0,025238
0,978563
(0,001266)
(0,033349)
(0,030015) (0,026239)
0,002236
-0,041385
0,001040
(0,001233)
(0,024026)
(0,013529) (0,024026)
0,001852
-0,043356
-0,016556
HP λ=129600
Quadratic trend
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0,968475
0,903297
0,908340
0,902158
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(0,028605)
(0,013433) (0,025119)
The policy rule specification that includes a lagged variable of the interest rate has
high explanatory power, as expected. If one drops the lagged interest rate variable, the
explanatory power of the model will be lower. We proceeded also to the estimation of the
classic Taylor rule. The results are presented below:
Table 6: Estimated Policy Rules for Euro Area (1999-2009) using the original Taylor
formulation
Output Gap
α
β
γ
HP λ=1600
0,043969
-0,002297
0,654320
(0,003421)
(0,001603)
(0,065036)
0,043973
-0,002303
0,526572
(0,003756)
(0,001760)
(0,059953)
0,039034
-0,000316
0,420757
(0,004418)
(0,002067)
(0,063794)
HP λ=129600
Quadratic trend
0,711975
0,653251
0,515199
Table 7: Estimated Policy Rules for German data (1960 - 1998) using the original Taylor
formulation
Output Gap
α
β
γ
HP λ=1600
0,043654
0,496266
0,188768
(0,002902)
(0,090149)
(0,090149)
0,043755
0,492391
0,020215
(0,003047)
(0,084836)
(0,043607)
0,042313
0,540426
0,104523
HP λ=129600
Quadratic trend
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(0,081591)
(0,043292)
The parameter estimates are robust across the different output gap measures,
suggesting that the different methods used to estimate the output gap do not affect
significantly the results of the study. Analyzing the different methods of estimation one can
see that the better fit is provided by using GMM, which is in fact the standard procedure to
analyze interest rates through a Taylor rule framework. The estimates obtained using OLS are
not reliable and the model has low explicative power, due to violation of OLS assumptions.
The results reported by the statistical software suggest a strong response to inflation in
the case of German data, while there is a softer response through interest rates to inflationary
pressures in the Euro Area. This suggests that the Euro Area monetary is more
accommodative than the central bank declares. The output gap measures are not significant
for the German data, suggesting that the Bundesbank is not accommodating its monetary
policy to output gap deviations. This finding is consistent with other research papers’ results.
The Bundesbank has been following a strict inflation targeting regime and its
monetary policy was in general stabilizing from this point of view. Plotting a target interest
rate against the actual interest rates in Germany reveals a good description of the direction
change in the monetary policy stance, though there is a level difference between the two
variables. This suggests that the Taylor framework is useful to bear in mind when analyzing
the direction of the monetary policy, but not to incorporate in an analysis that would try to
predict closely the level of future interest rates. This is consistent with what the Taylor rule is
in practice: a rule of thumb for which there is no consensus in the literature of the precise
function specification.
The interest rate in the Euro Area is tracked quite well by the Taylor rule, taking into
account three different output gap estimations used in the analysis. The changing points occur
in the same region suggesting that from a Taylor rule perspective, the central banks has done a
neat job at reacting to changes in output gaps and inflation changes. However, the magnitude
of the response does not seem to be tracked very well by such an approach. There is a derail
from the inflation targeting goal of the monetary policy for the Euro Area data, which
suggests that there is a concern towards output gap from the part of the central bank. As for
Germany, the evidence confirms the conclusion of the major papers in this area: the
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Bundesbank is following a strict inflation targeting regime and the original Taylor rule, that
gives 0,5 weight on the output gap does not have a very big predictive power. The parameter
estimates for the output gap come consistently insignificant and even the sign of the estimates
are not the expected ones. For inflation rate coefficients however, there is a good estimation
of the parameters and the sign is negative, as expected. In the Euro Area the magnitude of the
inflation rate coefficient is smaller than one, suggesting a destabilizing monetary policy.
These findings are consistent with other studies that focused on the Euro Area datasets. The
results are to be interpreted with caution, though, as normally one should have more data
available to be capable to reach conclusions with confidence. As for its short existence, the
monetary policy in the Euro Area seems not to follow a too strict inflation targeting regime.
Another finding after analyzing the data is that there is a significant difference between the
monetary policy in the Euro Area under different officers. Both the Chow break point test and
the Chow forecast test reject the null hypothesis of no structural break. This can be seen at
looking at the graphs with the actual interest rates versus the target interest rates. One can
easily see the greater derail from the inflation targeting under J.C.Trichet’s office.
There is a consensus in the macroeconomic literature that monetary policy is better
suited to perform short run stabilization purposes in comparison with fiscal policy. This
finding is very well applicable to the Euro Area: there is no fiscal unity among the states that
have the same currency and, naturally, it is the role of the central bank to act in this direction.
The evidence from the data confirms this statement: the main refinancing rates are determined
both by inflation and output gap developments in the Euro Area. This is consistent with what
monetary policy can do: even if in the long run the central bank has control only over
inflation, it can affect the variability of real variables both in the long and short term. That is
why stabilizing actions are essential to efficient monetary policy.
The financial crisis from 2007-2009 has challenged the idea of a unified Europe. The
Central Bank and the European Commission took preemptive actions to counteract
developments in the financial markets. There were many voices that criticized the monetary
policy in the Euro Area, considering that there was no sufficient action from the part of the
central bank. There was a continuous comparison with the actions took by the Federal
Reserve and many considered that the monetary stance was too tight. The counter argument to
such critics is that the main objective of the ECB remains price stability and that the central
bank should not derail from its purpose. However, understanding the uniqueness of the
situation, there have been extended lines of credit and nonstandard refinancing facilities at the
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central bank. So, from the financial crisis perspective, the central bank kept a balance between
the unusual needs of the financial system and the economy, while having in mind its main
objective - that of delivering low inflation rates to the euro area households.
One should not wrongly understand the role of the monetary policy for financial
stability – there is the monetary policy on one hand, and there is a whole institutional
framework needed in order to achieve financial stability. There is a need for a well
functioning payment system that is compatible with the objective of low inflation. The
financial stability objective is very large and it encompasses not only monetary policy, but
also fiscal policy and market developments, like asset price bubbles and failures of markets.
The issue of financial stability has arisen as a very important goal for most central banks.
There are periodic publications from the part of the European Central Bank focused on
financial stability. However, one important part of financial stability is monetary policy.
As in the case of the Euro Area data, the German response to output gaps and inflation
developments seem to be described quite well by a Taylor rule type of equation. The changing
points in the monetary policy reflect the same direction as the Taylor rule would suggest, with
a single exception, during the 1970-1975 period, after the German economy was hit by the oil
price shocks. The Taylor rule would have suggested a stricter action in order to dampen
inflationary pressures, which is not the case in practice, as the Bundesbank initially raised
interest rates and then, after facing a strongly slowing economy has taken a more
accommodative stance of the monetary policy. As the easing monetary policy did some relief
to the economy, the inflationary pressures spiked and the central bank had to raise interest
rates again. The period mentioned is the only one in the data set when the Bundesbank did not
follow strictly the inflation targeting regime. For the rest of the time, the interest rates were
continuously adjusted to achieve the main objective: low inflation rates.
The evidence suggests that there is some degree of interest rate smoothing in both sets
of data. As it can be seen from the graph, there is a truncation of the interest rate on one hand,
and less willingness to lower interest rates below a threshold level. Some degree of truncation
is due to the periodical announcement of the main refinancing rates that come usually after the
analyses of the central banks find relevant data that would call for a change in the rates.
Another reason for such behavior is that there is an asymmetric response to rises versus falls
in inflation rates and output gaps. These findings are consistent with those in (Clarida R.
Gertler M., 1996) that suggest that the Bundesbank is taking a more aggressive action when
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the inflation rate is above target in comparison to the easing policy, when the inflation rate is
below target. For example, during the last financial crisis, the underlying suggested a bigger
easing on the part of the ECB. In fact, the European Central Bank was criticized for keeping
the interest rates too high in 2009. The reply was that the aim of the central bank is to keep
inflation rate below, but close to two percent in the medium term. To prove them true, the
inflation rates started to pick momentum in 2010 as the economic recovery was on track,
though at a moderate pace.
The ECB staff conducts a regular monetary and economic analysis before taking the
regular decisions on the interest rate level. There is also a cross check between the monetary
analysis and the economic analysis. The medium term horizon is seen as the policy relevant
time frame and it is in the medium term that the bank analyses inflation developments in the
Euro Area. While acknowledging the state of the economy based on its analyses, the ECB
officials always tend to give a precautionary perspective, suggesting that uncertainties prevail.
Figure 8: Estimated Taylor rates versus the actual interest:
a. Germany
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b. Euro Area
The ECB officials are very proud of their results on inflation targeting as the
declaration of Jean Claude Trichet on September 2010 reveals:
”…Over the first eleven and a half years, we have delivered, as an average, a yearly
inflation average of 1.97%, less than 2, but close to 2%. All the information we are extracting
from financial markets are confirming that for the next 5 years they are projecting also price
developments in line with our definition of price stability… This is a very impressive period of
time and…what we have delivered to our fellow citizens, is the best result that has been
observed since 50 years in Europe”.
From this perspective, the ECB proves that it aims at being a credible central bank that
would not derail from its overriding principle. Inflation targeting, is in the ECB view,
essential to financial stability and it does not contradict with an accommodative policy during
economic downturn. Monetary policy easing is expected and efficient during recessions, as
prices normally tend to fall due to lower demand in such periods. Lower inflationary pressures
mean more space for monetary support to the real economy.
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This is not seen as contradicting with the accommodative monetary policy conducted
during the financial crisis and in the period immediately following. Moreover, in the October
staff conference, J.C.Trichet argues:
“…The current monetary policy stance remains accommodative. The stance, the
provision of liquidity and the allotment moods will be adjusted as appropriate taking into
account the fact that all nonstandard measures taken during the period of acute financial
market tensions are fully consistent with our mandate and by construction temporarily in
nature”.
There are standard measures put in place in order to deliver price stability and the bank
is providing nonstandard measures during crises. This is seen fully compatible with the price
stability objective and the public’s expectations.
Taking into account the declarations of the ECB officials and the empirical evidence
from the data that has been analyzed using a Taylor rule framework, the thesis will further
develop a model of its own to describe the interest rate setting mechanism in the Euro Area.
The model assumed is in the spirit of a Taylor rule, but it takes into account more variables.
The estimated equations are:
Equation 4:
Equation 5:
Equation 6:
where,
R
C(1)
is the main refinancing rate
is the intercept term
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The results of the estimation of these three equations by using GMM are presented
below:
Table 8: Estimation results of equation 4, 5 and 6:
Eq.4.
c(1)
c(2)
c(3)
c(4)
c(5)
c(6)
0.864547
0,014123
-0,000242
0,361892
-0,077106
-0,147433
0,902189
(0,000182)
(0,00006)
(0,005023) (0,006737) (0,004171) (0,006469)
0,000
0,0005
0,0000
Eq.5.
c(1)
c(2)
c(3)
c(4)
c(5)
0,897010
0,034984
0,001211
0,626642
0,034444
-0,017306
(0,000185)
(0,000209)
(0,002797)
(0,006538)
(0,004576)
0,0000
0,0000
0,0000
0,0000
0,0000
0,0000
0,0000
0,0000
Eq.5.
c(1)
c(2)
c(3)
c(4)
0,678368
0,020384
-0,003540
-0,074753
0,307341
(0,000150)
(0,000183)
(0,007479)
(0,003763)
0,0000
0,0000
0,0000
0,0000
As the economic intuition would suggest, the model specified by equation 5 is closest
to the optimal one for setting the main refinancing rates in the Euro Area. After determining
that the monetary policy in the Euro Area is accommodating, one should understand what are
the variables that influence the monetary authorities when setting the monetary policy stance.
As expected, the output gap is significant from this point of view and the parameter value is
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around 0,5 in all the hypothetical rules considered. This confirms the finding that the
monetary policy in the Euro Area is accommodative in nature.
Analyzing the declarations of the ECB officials after the Govening Council meetings,
one intuition has emerged: the monetary policy is having a close view on the productivity
developments in the Euro Area and the M3 and credit to private sector growth. These
variables were included as explanatory variables in the regression and they are significant at
the 5% level. For further research, one should incorporate into analysis a foreign exchange
measure, commodity prices and labor market developments.
This policy rule proposed is a better framework to interpret the Euro Area data. The
annexes present the output of the different test performed both on the original Taylor rule, the
policy function including a lagged value of the interest rate and the proposed rule.
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Conclusions
Our conclusions are subject to the caveat that they come from a limited time series for
the European Union and that they are subject to the model specification chosen. There are still
many questions over how to best conduct monetary policy. However, the answer is always in
connection with how an economy’s businesses, households, and banks behave in the contexts
of a specific economic reality and institutional arrangements.
One major conclusion is that the monetary policy of the ECB and that of Bundesbank
can be interpreted in terms of the Taylor rule framework with surprising consistency. The
estimated equations indicate that the rules examined describe broadly the time path of policy
decisions quite close. The responses to output gap and to movements in the price level are as
expected. The magnitude of the response to inflation is in line with the classical formulation
of the Taylor rule but it is not in line with the assumed inflation targeting monetary policy.
The findings are in line with studies in this area that suggest that since the introduction
of the euro and the conduct of a single monetary policy, in the Euro Area the monetary policy
is rather accommodative than stabilizing (K. Ulrich, 2003). Taking into account the findings
of other papers, one can easily see that the Taylor rule can be used as a framework in order to
evaluate the interest rate setting mechanism in the Euro Area, but no one would make a profit
out of such a strategy, as the rule does not fit the data as well as it did for the sample taken
into consideration by Taylor’s original paper. The evidence suggests also that there is a
significant difference between the monetary policy in the Euro area during the office of W.
Druisenberg and the monetary policy conducted under J.C.Trichet.
The empirical evidence suggests that the interest rates in the euro area are in line with
the levels the framework would predict, suggesting a rather accommodative monetary policy
of the ECB. There is a greater weight on the output gap than the focus on inflationary
pressures, in contrast with the Bundesbank monetary policy, which follows a strict inflation
targeting regime. In fact, the ECB is following a “flexible inflation targeting”, having
inflation stability as a primary goal and putting some weight on stabilizing output movements.
By developig a policy reaction function that includes M3 growth and productivity in
addition to the inflation rates and output gap, the thesis finds that such a model is a better fit
to describe the level of the main refinancing rates in the Euro Area.
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Annexes:
7.1. Data
Inflation and Interest rates:
a. Euro Area(1999 - 2009)
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b.Germany
(1961-1999)
Real GDP (Volume):
a. Euro Area(1999 – 2009)
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b. Germany(1961-1999)
Real GDP growth:
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Real Rate versus Output Gap:
a. Euro Area (1999-2009)
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b. Germany(1961-1998)
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7.2. Stationarity tests output
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A summary of the Augmented Dickey Fuller, Phillips – Perron and Kwiatkowski – Phillips –
Schmidt – Shin tests is presented in the next two tables:
In the euro area time series we have:
ADF
Test
Test
specification
4
5
PP
– Test
P
value
KPSS
P
– Test
value
5%
level4
C5
-5,710651
0,0000
-5,844074
0,0000
0,103035 0,463000
T
-5,854868
0,0001
-5,943827
0,0001
0,078732 0,146000
C
-4,789732
0,0003
-4,796327
0,0003
0,181020 0,463000
T
-4,876081
0,0016
-4,876625
0,0016
0,048709 0,146000
C
-3,363997
0,0181
-3,473696
0,0137
0,158137 0,463000
T
-3,531827
0,0488
-3,645543
0,0378
0,105170 0,146000
C
-3,030424
0,0401
-3,030424
0,0401
T
-3,291341
0,0816
-3,395661
0,0656
A bigger test value than the 5% level is interpreted as one can reject the null hypothesis of stationarity
C - One constant is included; T - One constant and a trend are included
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For the German data, the results are:
ADF
PP
Test
P – value
Test
P – value
C
-5,426038
0,0000
-5,204046
0,0000
T
-5,428314
0,0001
-5,194027
0,0002
C
-12,18084
0,0000
-12,27366
0,0000
T
-12,25927
0,0000
-12,33991
0,0000
C
-11,18764
0,0000
-11,16688
0,0000
T
-11,14856
0,0000
-11,12693
0,0000
Test
specification
7.3. Output gap estimations:
a. Euro Area(1999 - 2009)
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b. Germany (1961-1999)
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7.4. Equation estimation output
a. Euro Area
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b. Germany:
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7.5. Coefficient and residual tests:
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7.6. VAR evidence:
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