Top

Empirical Economics

Published in:

01-05-2014

Zero lower bound, ECB interest rate policy and the financial crisis

Published in: Empirical Economics | Issue 3/2014

Activate our intelligent search to find suitable subject content or patents.

search-config

AI-assisted search

Off

Abstract

We explore whether the ECB’s interest rate setting behaviour changed during the financial crisis by estimating reaction functions over the period 1999–2010, allowing for a smooth transition from one set of parameters to another. The estimates show a swift change in the months following the collapse of Lehman brothers. The ECB appears to have cut rates more aggressively than expected solely on the basis of the worsening of macroeconomic conditions, consistent with the theoretical literature on optimal monetary policy in the vicinity of the zero bound.

previous article Measuring the effects of monetary policy in Pakistan: a factor-augmented vector autoregressive approach

next article The predictive power of yield spread: evidence from wavelet analysis

Dont have a licence yet? Then find out more about our products and how to get one now:

Springer Professional "Wirtschaft"

Online-Abonnement

Mit Springer Professional "Wirtschaft" erhalten Sie Zugriff auf:

über 67.000 Bücher
über 340 Zeitschriften

aus folgenden Fachgebieten:

Bauwesen + Immobilien
Business IT + Informatik
Finance + Banking
Management + Führung
Marketing + Vertrieb
Versicherung + Risiko

Jetzt Wissensvorsprung sichern!

inform now

Springer Professional "Wirtschaft+Technik"

Online-Abonnement

Mit Springer Professional "Wirtschaft+Technik" erhalten Sie Zugriff auf:

über 102.000 Bücher
über 537 Zeitschriften

aus folgenden Fachgebieten:

Automobil + Motoren
Bauwesen + Immobilien
Business IT + Informatik
Elektrotechnik + Elektronik
Energie + Nachhaltigkeit
Finance + Banking
Management + Führung
Marketing + Vertrieb
Maschinenbau + Werkstoffe
Versicherung + Risiko

Jetzt Wissensvorsprung sichern!

inform now

Available only for authorised users

We use the term “zero lower bound” to denote the lower bound regardless of its exact numerical value.

See Ullersma (2002) for a survey of the literature on the ZLB.

Viñals (2001) contains an overview discussion of the consequences of the ZLB. See also Gerlach et al. (2009), Reifschneider and Williams (2000), Viñals (2001), and Coenen et al. (2004).

See Orphanides and Wieland (2000); Svensson (2001) or Coenen and Wieland (2003, 2004).

Adam and Billi (2006) reach a similar conclusion based on the expectations channel using a standard forward-looking New Keynesian model, as do Orphanides and Wieland (2000) using dynamic programming techniques.

To check whether this choice of dependent variable is driving our results, we also re-estimated our model using the repo rate as a dependent variable. This yields results very similar to those reported in the main paper (full results available from the authors on request).

Note that the inclusion a variable in the ECB reaction function does not imply it appears in ECB’s objective function. Svensson (1997) shows that even if the sole objective of policy is to stabilise inflation, the central bank should react to any variable which helps forecast future inflation.

While this approach is similar to that of Mankiw et al. (1987), the STR approach assumes a constant error variance. Estimating the model using their approach yields very similar results and the hypothesis of constant variance is not rejected.

Inflation, money growth and the rate of depreciation are all measured over 12 months.

The switching point is estimated as 225.4 and the time trend takes the value 225 in October and 226 in November. Hence, we refer to the two periods as “pre-crisis” and “crisis.”

The turbulence in the interbank market caused by fears about the millennium bug, and the fact that this effect peaked prior to December 1999 have been documented elsewhere. See for example Bank of England (2000) or Gerlach (2007).

These were tested against a version of the unrestricted model which included the two single-period dummies mentioned above. This intermediate regression is not reported for space reasons.

For full results please, see Table 4 in the Appendix.

Results for different interest rates and inclusion of financial variables are not reported for space reasons.

Thus, in constructing these forecasts we use the actual value of all the regressors, except past values of the interest rate, for which we use forecasted values.

We also estimated a version of the model in which the regime in force depends on the lagged level of the interest rate, but did obtain any useful estimates.

This means we use first release, rather than revised data for GDP. Since data are only available on a quarterly basis, we interpolate to obtain monthly figures.

We abstract from publication lags in this analysis. We assume that the ECB could have nowcast the current quarters GDP with reasonably accuracy. Our results locate the midpoint of the switch when GDP is 2.6 percentage points below trend. This is much larger than the typical forecast errors associated with nowcasts, or 1 quarter ahead GDP forecasts, which tend to be around 0.2 (Angelini et al. 2008).

If our gap measure is included in the pre-crisis reaction function alongside the PMI, the former is insignificant, and the latter remains highly significant.

A likelihood ratio test of these restrictions yields p = 0.967, so the restrictions are accepted

Adam K, Billi R (2006) Optimal monetary policy under commitment with a zero bound on nominal interest rates. J Money Credit Bank 38(7):1877–1905CrossRef

Angelini E, Camba-Mendez G, Gonzalo C, Giannone D (2008) Short-term forecasts of Euro area GDP growth. ECB Working Paper No. 949

Bank of England (2000) Quarterly bulletin. Bank of England, London

Bini Smaghi L (2008) Careful with the ‘\(d\)’ words!, speech given in the European Colloquia Series, Venice, 25 November

Carstensen K (2006) Estimating the ECB reaction function. Ger Econ Rev 7(2):1–34CrossRef

Coenen G, Wieland V (2003) The zero-interest-rate bound and the role of the exchange rate for monetary policy in Japan. J Monet Econ 50:1071–1101CrossRef

Coenen G, Wieland V (2004) Exchange rate policy and the zero bound on nominal interest rates. Am Econ Rev Pap Proc 94:80–84CrossRef

Coenen G, Orphanides A, Wieland V (2004) Price stability and monetary policy effectiveness when nominal interest rates are bounded at zero. Adv Macroecon 4:1–23CrossRef

Fisher I (1896) Appreciation and interest. McMillan, New York

Gerlach S (2003) Recession aversion, output and the Kydland-Prescott Barro-Gordon model. Econ Lett 81:389–394

Gerlach S (2007) Interest rate setting by the ECB, 199–2006: words and deeds. Int J Central Bank 3:1–45

Gerlach S (2008) Forecasting ECB’s interest rate decisions: a background note. Unpublished.

Gerlach S (2011) ECB repo rate setting during the financial crisis. Econ Lett 112:186–188CrossRef

Gerlach S, Cukierman A (2003) The inflation bias revisited: Theory and some international evidence. Manch Sch 71(5):541–565

Gerlach S, Giovannini A, Tille C, Viñals J (2009) Are the golden Years of Central Banking over? The crisis and the challenges. Geneva Reports on the World Economy 10, ICMB and CEPR

Gorter J, Stolwijk F, Jacobs J, de Haan J (2010) ECB Policymaking and the financial crisis. DNB Working Paper 272

Judd J, Rudebusch J (1998) Taylor’s rule and the fed: 1970–1997. Fed Reserv Bank San Franc Econ Rev 3:3–16

Keynes J (1936) The general theory of employment, interest and money. Cambridge University Press, Cambridge

Mankiw N, Miron J, Weil J (1987) The adjustment of expectations to a change in regime: a study of the founding of the federal reserve. Am Econ Rev 77(3):358–374

Mathieson T (2011) Financial conditions indices for the United States and Euro area. IMF Working Paper 11/93

Orphanides A, van Norden S (2002) The unreliability of output gap estimates in real time. Rev Econ Stat 84(4):569–583CrossRef

Orphanides A, van Norden S (2005) The reliability of inflation forecasts based on output gap estimates in real time. J Money Credit Bank 37(3):583–601CrossRef

Orphanides A, Wieland V (2000) Efficient monetary policy design near price stability. J Jpn Int Econ 14:327–365CrossRef

Reifschneider D, Williams J (2000) Three lessons for monetary policy in a low-inflation era. J Money Credit Bank 32(4):936–966CrossRef

Summers L (1991) How should long-term monetary policy be determined? J Money Credit Bank 233:625–631CrossRef

Svensson L (1997) Inflation forecast targeting: implementing and monitoring inflation targets. Eur Econ Rev 41:1111–1146CrossRef

Svensson L (2001) The zero bound in an open economy: a foolproof way of escaping from a liquidity trap. Monet Econ Stud 19(S-1):277–312

Teräsvirta T (1988) Testing linearity against smooth transition autoregressive models. Biometrika 75:491–499CrossRef

Teräsvirta T (1994) Specification, estimation and evaluation of smooth transition autoregressive models. J Am Stat Assoc 89(425):208–218

Teräsvirta T (2004) Smooth transition regression modelling. In: Lütkepohl Krätzig (ed) Applied time series econometrics. Cambridge University Press, New York

Ullersma C (2002) The zero bound on nominal interest rates and monetary policy effectiveness: a survey. De Economist 150(3):273–297CrossRef

Viñals J (2001) Monetary policy issues in a low inflation environment. In: García Herrero A, Gaspar V, Hoogduin L, Morgan J, Winkler B (eds) Why price stability? ECB, Frankfurt

Title: Zero lower bound, ECB interest rate policy and the financial crisis
Publication date: 01-05-2014
Published in: Empirical Economics / Issue 3/2014
Print ISSN: 0377-7332
Electronic ISSN: 1435-8921
DOI: https://doi.org/10.1007/s00181-013-0713-6

Springer Professional

Abstract

Please log in to get access to your license.

Dont have a licence yet? Then find out more about our products and how to get one now:

Springer Professional "Wirtschaft"

Springer Professional "Wirtschaft+Technik"

Other articles of this Issue 3/2014

The predictive power of yield spread: evidence from wavelet analysis

Sticky information and inflation persistence: evidence from the U.S. data

Household food consumption, individual caloric intake and obesity in France

Choosing and using payment instruments: evidence from German microdata

Evaluating changes in the monetary transmission mechanism in the Czech Republic

Why does monetary policy respond to the real exchange rate in small open economies? A Bayesian perspective