Blog Post

-15% to +4%: Taylor-rule interest rates for euro area countries

Does one size fit all? Before the crisis, there was a major debate on whether the single interest rate set by the European Central Bank (ECB) would be suitable for all members of the euro area, which have diverse economic conditions.

By: and Date: September 18, 2013 Topic: European Macroeconomics & Governance

Before the crisis, there was a major debate on whether the single interest rate set by the European Central Bank (ECB) would be suitable for all members of the euro area, which have diverse economic conditions. The debate became quieter since the euro-crisis, as there is now widespread recognition that this is not the case. Moreover, financial fragmentation, which has emerged with the crisis, made things even worse.

There is an extensive academic research on monetary policy rules and it is frequently found that a rather simple Taylor-rule, which prescribes the central bank interest rate as a function of inflation and a measure of economic activity, describes reasonably well actual central bank interest rates developments (see John Taylor’s webpage on monetary policy rules here).

In a 2011 FRBSF Economic Letter Fernanda Nechio calculated Taylor-rule recommendations for the euro-area as whole, plus separately for the euro-area core and periphery, basing the rule on core inflation and the unemployment gap. She showed that for the euro-area aggregate the ECB’s interest rate well follows the recommendation of the rule, but the diverse economic developments within the euro-area make the rate suboptimal for the two groups considered separately, and especially for the periphery.

We used Nechio’s version of the Taylor-rule to calculate recommendations for the euro area as a whole, plus for first twelve euro member states individually, over the period 1999Q1-2013Q3. Figure 1 reports our results and Figure 2 the underlying data we use. Panel A of Figure 1 shows the ECB’s actual Main Refinancing Operations (MRO) interest rate and the Taylor-rule recommendation. The two lines are not that far apart, suggesting that this simple Taylor-rule is not a too bad description of actual policies (in most part of the sample period, actual interest rate changes precede the changes in the recommended interest rate, most likely because the ECB’s Governing Council took a forward-looking view and acted in anticipation of future changes in economic conditions).

The next three panels show the recommendations for the twelve countries, in comparison with the euro-area aggregate. The countries are ordered according to the average absolute deviation from the euro-area recommendation in 1999-2013. This ranking is topped by France, suggesting that in this country the developments are the closest to the euro area average. Greece and Ireland are instead the farthest from the euro-area average. The recommendations for Germany, the largest country in the euro area, were also quite apart from the euro-area average but in the opposite direction than in Ireland: the ECB’s policy was too tight for Germany before the crisis, and too loose now, according to the version of the Taylor-rule we adopted.

Figure 1: Taylor-rule recommendations for the central bank interest rate (percent per year), 1999Q1-2013Q3

Notes: Taylor-rule target = 1 + 1.5 x  Inflation – 1 x Unemployment gap. Similarly to Mechio (2011), we use core inflation (all items HICP excluding volatile food and energy prices; change relative to the same quarter of the previous year) and the deviation of the actual unemployment rate from the estimated non-accelerating inflation rate of unemployment (NAIRU), as estimated by the OECD. MRO = Main refinancing operations. The 2013Q3 recommendations are based on July-August 2013 inflation rate and the July 2013 unemployment rate.

The most recent recommendations would suggest that conditions in Ireland, Spain, Portugal and Greece are such to warrant even a negative interest rate (minus 15 percent in Greece!), whereas the optimal prescription for Austria, Germany and Luxembourg would be a positive interest rate of about four percent. In theory, such differences can help to rebalance intra-euro price-competitiveness divergences, whereby a boom in Germany increases prices and wages, while the high unemployment in Spain reduces them. But when unemployment is as high as in Spain, increasing unemployment further should not be the way to go and in Germany prices do not increase much despite low unemployment.

Therefore, the other side of the coin is that those countries experiencing the most depressed economic conditions face at present very tight monetary conditions, while countries in which the economic situation is better get loose monetary policy. What is more, the vicious circle linking together banks and sovereigns (whereby banks hold a large amount of debt of the government of their country of residence and are expected to be bailed out by the same government, with negative implication for the debt sustainability of the latter) in some euro-area countries further pushed both banks and governments to the abyss, thereby leading to even larger nominal interest rates.

What’s the solution to this quandary? We note that divergences are not uncommon in other currency areas, like the United States (though certainly less extreme than in the euro area now). In the US, however, the intra-state adjustment capacity, such as labour mobility, is much stronger. Plus there is a large federal budget which helps to smooth regional economic shocks. These would also be the way to go for the euro area: improving cross-country adjustment capacity through rigorous structural reforms, better regulation and proper incentives for cross-country mobility, as well as designing a fiscal capacity for the euro area. Beyond these tasks, the vicious circle between banks and sovereigns should be fully broken. The project of banking union was initially expected to deal with this issue, but to ensure its success a more ambitious banking union would be needed than what is on the cards now. And there is a case, in the first place, to act pre-emptively and limit divergences before they become excessive: the EU’s Macroeconomic Imbalances Procedure aims to do that, and entrusting the ECB with macro-prudential tools – as currently envisaged in the Single Supervisory Mechanism (SSM) proposal – may also help. But these latter tools can only help once the euro-area recovers from the current gloom, which is unfortunately seems to be far off. In the meantime, given the powerlessness of the traditional interest rate channel, other ways to ease the credit conditions in the South of the euro area should be explored, such as improving the access of SMEs to credit, by means for example of a properly designed scheme for targeted central bank lending, after bank balance sheets have been cleaned-up (Darvas, 2013).

Figure 2: Core inflation, the unemployment rate and the estimated NAIRU (non-accelerating inflation rate of unemployment), percent

Note: the OECD’s NAIRU (non-accelerating inflation rate of unemployment) estimate is available at the annual frequency. We converted it to quarterly frequency by using a filter which assumes smooth change within the year.

 

 


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.


Warning: Invalid argument supplied for foreach() in /home/bruegelo/public_html/wp-content/themes/bruegel/content.php on line 449
View comments
Read about event More on this topic

Upcoming Event

Jan
24
12:30

Towards a new social contract

This event will look at a a proposal for a new social contract put forward by the World Bank.

Speakers: Maurizio Bussolo, Zsolt Darvas, Ruby Gropas and Bernadette Ségol Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More on this topic More by this author

Blog Post

Is public debt a cheap lunch?

The fiscal and welfare costs of public debt, following Olivier Blanchard's presidential lecture at the American Economic Association, in which he suggested both might be lower than expected. We review his paper, along with several scholars' comments, and provide a quick comparison with the European context.

By: Jan Mazza Topic: European Macroeconomics & Governance Date: January 21, 2019
Read article Download PDF More on this topic

External Publication

Analysis of developments in EU capital flows in the global context

The monitoring and analysis of capital movements is essential for policymakers, given that capital flows can have welfare implications. This report, commissioned by the European Commission’s Directorate-General for Financial Stability, Financial Services and Capital Markets Union, aims to analyse capital movements in the European Union in a global context.

By: Grégory Claeys, Maria Demertzis, Konstantinos Efstathiou, Inês Goncalves Raposo, Alexander Lehmann and David Pichler Topic: European Macroeconomics & Governance Date: January 17, 2019
Read article More on this topic More by this author

Podcast

Podcast

Director's Cut: The economics of no-deal Brexit

Bruegel director Guntram Wolff is joined by senior fellow Zsolt Darvas to rake through the possibilities and probabilities inherent in a no-deal Brexit scenario, covering trade, the Irish border, citizens' rights and the EU budget.

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: January 16, 2019
Read article More by this author

Blog Post

What 2019 could bring: A look inside the crystal ball

Economic performance prospects in Europe, the US and Asia in 2019. We start off by reviewing commentaries and predictions about the euro zone, which many commentators expect to perform below potential as uncertainties continue to dampen a still robust recovery.

By: Michael Baltensperger Topic: European Macroeconomics & Governance, Global Economics & Governance Date: January 14, 2019
Read article More on this topic More by this author

Blog Post

EU budget implications of a no-deal Brexit

A no-deal Brexit would mean the UK’s contributions to the EU budget fall to zero as of March 30th 2019. The author here calculates an estimate of the budget shortfall that would have to be covered in this case, and how the burden would fall across different member states.

By: Zsolt Darvas Topic: European Macroeconomics & Governance Date: January 14, 2019
Read article Download PDF More on this topic More by this author

Policy Contribution

The implications of no-deal Brexit: is the European Union prepared?

The author, based on a note written for the Bundestag EU Committee, is exploring the possible consequences of a no-deal Brexit for the EU, assessing preparations on the EU side and providing guidance on the optimal strategy for the EU, depending on the choices made by the United Kingdom.

By: Guntram B. Wolff Topic: European Macroeconomics & Governance Date: January 14, 2019
Read article Download PDF More by this author

Parliamentary Testimony

German Bundestag

The implications of no-deal Brexit: is the EU prepared?

Hearing on Brexit in the EU Committee of Bundestag on 14 January 2019, exploring the possible consequences of a no-deal Brexit for the EU and assessing preparations on the EU side.

By: Guntram B. Wolff Topic: European Macroeconomics & Governance, German Bundestag, Testimonies Date: January 14, 2019
Read article More on this topic More by this author

Opinion

Fifty shades of yellow

Who are the Yellow Vests? What are the true roots of their uprising? And what do they want? Six weeks after they started rocking French politics and a month after violence erupted on the Champs Élysées, these questions are still hotly debated in France.

By: Jean Pisani-Ferry Topic: European Macroeconomics & Governance Date: January 10, 2019
Read article More by this author

Podcast

Podcast

Director’s cut: Wrapping up 2018

With 2018 drawing to a close, and the dawn of 2019 imminent, Bruegel's scholars reflect on the economic policy developments we can expect in the new year – one that brings with it the additional uncertainty of European elections.

By: The Sound of Economics Topic: Energy & Climate, European Macroeconomics & Governance, Finance & Financial Regulation, Global Economics & Governance, Innovation & Competition Policy Date: December 20, 2018
Read article Download PDF More on this topic

Policy Contribution

The euro as an international currency

Is a more important international role for the euro worth pursuing? What measures would achieve this result, if it is worth pursuing?

By: Konstantinos Efstathiou and Francesco Papadia Topic: European Macroeconomics & Governance Date: December 18, 2018
Read article More on this topic More by this author

Blog Post

Brexit: Now for something completely different?

The life of Brexit. After a week of ECJ rulings, delayed votes, Theresa May’s errands across Europe and the vote of no confidence, we review the latest economists’ opinions to try to make sense of what has changed and what hasn’t.

By: Inês Goncalves Raposo Topic: European Macroeconomics & Governance Date: December 17, 2018
Load more posts