Abstract
The financial crisis that started in August 2007 deeply changed the modus operandi of monetary policy on both sides of the Atlantic Ocean and stimulated a debate about how to formally define and practically implement newly relevant objectives, such as systemic stability, in the reaction function of the Monetary Authorities. This paper provides an assessment of the monetary policy decisions and interventions undertaken by the FED and the ECB, and evaluates the respective monetary policy regimes in place before and during the crisis according to the lessons derived from the theoretical literature on monetary policy developed in the last 2 decades.
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Notes
Notice that, although clearly different from a conceptual point of view, in the practice operative targets may be confused with policy tools, given that central banks are endowed with sufficient power in the interbank market so as to reach rapidly the desired level of target variables.
To tell the truth, even before 2003 the rate of growth of M3 was not de facto a true intermediate target. Broad money largely exceeded the target value without calling for correcting actions of the central bank. The ECB justified this inaction by relying on the second pillar of its monetary policy strategy, the so called economic and financial analysis (see the ECB web site for a complete description of the Eurosystem monetary policy regime).
See Di Giorgio and Nistico (2007) and the literature quoted in that paper.
The artificial series generated by the counterfactual Taylor rule is obtained via the following formula: \( r_{t}^{TR} = 1,5 \cdot \pi_{t} + 0,5 \cdot \tilde{x}_{t} , \) where \( \pi_{t} \) is current inflation, computed as percentage variation from one year ago of CPI index, and \( \tilde{x}_{t} \) is output gap as measured by Congressional Budget Office.
A complete list of such facilities is easily obtained (and carefully described) by visiting the websites of the Board of Governors of the Federal Reserve System. It includes the term securities lending facility, the term discount window facility, the term security lending facility options program, the ABCP money market fund liquidity facility, the commercial paper funding facility and other tools.
This late response is in evident contrast with the forward looking behaviour often advocated by academics as a necessary ingredient for monetary policy management.
See Driffill et al. (2006) for empirical evidence supporting the Fed’s reaction to basis risk based on an estimated Taylor-type rule.
See Hull (2000) for a discussion on the validity of this assumption.
Accordingly, rational agents expecting this behaviour from the central bank will find the basis risk reduced to zero. Clearly, such a policy rule would also imply no reaction to deviations of inflation or output from their trend level.
Notice that the fraction terms are all positive if \( \left[ {\left( {1 + \beta } \right)\lambda_{\varDelta } + \hat{\lambda }_{r} } \right] > 0 \), which holds under the calibrated parameter values considered in Woodford (2003).
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The author wish to thank Hakan Danis, Stefano Marzioni, Paul Johnson, and an anonymous referee for valuable comments. Any remaining mistake is only to him.
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Di Giorgio, G. Monetary policy challenges: how central banks changed their modus operandi. Eurasian Econ Rev 4, 25–43 (2014). https://doi.org/10.1007/s40822-014-0002-5
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DOI: https://doi.org/10.1007/s40822-014-0002-5