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Comparing monetary policy reaction functions: ECB versus Bundesbank

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Abstract

This paper compares the European Central Bank’s (ECB) conduct of monetary policy with that of the Bundesbank. Estimated monetary policy reaction functions show that the ECB reacts similarly to expected inflation but significantly stronger to the output gap than the Bundesbank did. Theoretical considerations suggest that this stronger response to the output gap may rather be due to a higher interest rate sensitivity of the German output gap than to a higher weight given to output stabilisation in the objective function of the ECB. Counterfactual simulations based on the estimated interest rate reaction functions reveal that German interest rates would not have been lower under a hypothetical Bundesbank regime after 1999. However, this conclusion crucially depends on the assumption of an unchanged long-run real interest rate for the EMU period and is reversed when the Bundesbank reaction function is adjusted for the lower long-run real interest rate estimated for the ECB regime.

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Notes

  1. See, for instance, “The Neglected Economy”, The Economist, 16 September 2002 or Steve Liesman, Wall Street Journal, 17 November 2002.

  2. The sample period is, however, too short to test for the significance of such potential asymmetries.

  3. As we will show in our discussion further below, such a Taylor rule is the optimal interest rate rule in a simple backward looking model of the economy proposed by Svensson (1997) and Ball (1999).

  4. Recent evidence shows that the explicit modelling of a lagged interest rate term is preferable to an autoregressive errors specification (Castelnuovo 2003).

  5. Alternative detrending methods such as a Hodrick–Prescott or a bandpass filter yield qualitatively similar results.

  6. It should be noted that the test of over-identifying restrictions in fact tests the joint hypotheses that the instruments are orthogonal to the error term and that the estimated model is correctly specified.

  7. The resulting instrument set is: interest rate (lags: 1, 2, 3), inflation (lags: 6), growth rate of the effective real exchange rate (lags: 1, 4), output gap (lags: 1, 2, 3, 6), the growth rate of the oil price index in DM (lags: 1, 6), and the monthly growth rate of the money aggregate M3 (lags: 2).

  8. In contrast, there is evidence that the Clarida et al. (1998a) specification suffers from problems with weak instruments. In their basic specification, Clarida et al. (1998a) use 48 instruments (p. 1045, Table 1). In the first-stage regression for the inflation rate the Stock and Yogo-test can barely reject the hypothesis of a bias of 10% of the OLS bias and cannot reject the Null that the nominally sized test statistics of a 5% level does not exceed a level of 15%.

  9. One could estimate a Taylor rule from 1979:4 to 2003:7 using German data and then test for a break in 1999:1. This would not take into account, however, that the ECB uses aggregate European variables in its rule.

  10. The requirement of a more than proportional response of the nominal interest rate to the inflation rate in order to deliver an increase in the real interest rate that ultimately stabilises the rise in inflation is referred to as the Taylor principle.

  11. Given that we employ a one-year ahead inflation rate, the actual estimation period ends in May 2003.

  12. The resulting instrument set is: interest rate (lags: 1,3), inflation (lags: 3,6), rate of change of the effective real exchange rate (lags: 1), output gap (lags: 4,5), the growth rate of the oil price index in EUR (lags: 1,3,6), and the monthly growth rate of the money aggregate M3MA (lags: 1,2,4,5,6).

  13. Normal standard errors are: ρ (0.038), β (0.782), γ (0.127), and α (1.72).

  14. See Peersman and Smets (2003), Peersman (2004), Hofmann (2005), and Clausen and Hayo (2005a).

  15. While it would in principle be possible to follow the approach of Favero and Rovelli (2003) and Castelnuovo and Surico (2003) by estimating a structural model of the euro area economy and a Taylor rule corresponding to the estimated structural model, the ECB regime is still too young to estimate these equations with quarterly data. Such an exercise would only be feasible by extending the sample size through the use of synthetic euro area data. However, drawing inferences about the ECB’s preferences based on pre-EMU observations, a period where monetary policy in Europe was largely shaped by the Bundesbank, would not be appropriate.

  16. A detailed derivation of the equation can be found in Svensson (1997).

  17. The intuition for this result is that a more gradual adjustment of inflation to its target level involves less output fluctuations. The higher the weight on output stabilisation, the more gradual inflation is therefore adjusted to its target level.

  18. However, it should be noted that our estimate of the long-run real interest rate in the euro area is consistent with the realised ex-post short-term real interest rate (daily money market rate less HICP inflation), which averaged 1.35% in the first five years of EMU.

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Acknowledgements

We thank two anonymous referees, Efrem Castelnuovo, Jürgen von Hagen, Dieter Nautz, Paolo Surico, and participants of the annual Money, Macro and Finance Group conference at CASS Business School for helpful comments. The usual disclaimer applies.

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Authors and Affiliations

  1. Faculty of Business Administration and Economics (FB 02), Philipps-University Marburg, Universitaetsstr. 24, 35037, Marburg, Germany

    Bernd Hayo

  2. Zentrum für Europäische Integrationsforschung, University of Bonn, Walter-Flex-Str. 3, 53113, Bonn, Germany

    Bernd Hayo & Boris Hofmann

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  1. Bernd Hayo
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  2. Boris Hofmann
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Correspondence to Bernd Hayo.

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Hayo, B., Hofmann, B. Comparing monetary policy reaction functions: ECB versus Bundesbank. Empirical Economics 31, 645–662 (2006). https://doi.org/10.1007/s00181-005-0040-7

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