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

Sep
12
16:30

Reforming Europe's fiscal framework

This event will discuss reforming Europe's fiscal framework.

Speakers: Zsolt Darvas, Lars Feld, Philippe Martin, Lucio Pench and Beatrice Pierluigi Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More on this topic

Blog Post

What should the EU do about the Turkish currency crisis?

The Turkish lira has been under significant pressure in recent weeks; in this blog post, the authors discuss the EU’s exposure to possible crisis in Turkey and how the EU should react.

By: Grégory Claeys and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: August 14, 2018
Read about event

Upcoming Event

Sep
3-4
08:30

Bruegel Annual Meetings 2018

The 2018 Annual Meetings will be held on 3-4 September and will feature sessions on European and global economic governance, as well as finance, energy and innovation.

Speakers: Maria Åsenius, Richard E. Baldwin, Carl Bildt, Maria Demertzis, Lowri Evans, Mariya Gabriel, Péter Kaderják, Joanne Kellermann, Jörg Kukies, Emmanuel Lagarrigue, Philippe Lespinard, Montserrat Mir Roca, Dominique Moïsi, Jean Pierre Mustier, Ana Palacio, Jean Pisani-Ferry, Lucrezia Reichlin, Norbert Röttgen, André Sapir, Jean-Claude Trichet, Johan Van Overtveldt, Martin Sandbu, Margrethe Vestager, Reinhilde Veugelers, Thomas Wieser, Guntram B. Wolff and Georg Zachmann Topic: Energy & Climate, European Macroeconomics & Governance, Finance & Financial Regulation, Global Economics & Governance, Innovation & Competition Policy Location: Brussels Comic Strip Museum, Rue des Sables 20, 1000 Brussels
Read article More on this topic

Opinion

Integrity of official statistics under threat

Andreas Georgiou has unwittingly become an international icon for statistical integrity. His continuing politically-motivated persecution is highly damaging for Greece, and more broadly for the credibility and reputation of the euro area.

By: Edwin M. Truman and Nicolas Véron Topic: European Macroeconomics & Governance Date: August 10, 2018
Read article More on this topic

Opinion

Europe should avoid a no-deal Brexit

The UK government finally tabled a serious proposal for the country’s future relationship with the European Union (EU). The White Paper puts the ball in the EU court as it now has to say what kind of relationship it wants to establish with its neighbour.

By: Jean Pisani-Ferry, Norbert Röttgen, André Sapir, Paul Tucker and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: July 24, 2018
Read article More on this topic More by this author

Opinion

Germany’s Government Still Has an Allergy to Investing

The new coalition budget looks a lot like the old German coalition budget.

By: Guntram B. Wolff Topic: European Macroeconomics & Governance Date: July 23, 2018
Read article More on this topic More by this author

Blog Post

Italy's "Dignity Decree"

The new Italian government pushed through its first legislative act including elements of labour market reform. Presented as an overturn of the previous government’s “Jobs Act”, the estimated effects of the decree are controversial. We review Italian economists’ view on the matter.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: July 23, 2018
Read article

Parliamentary Testimony

European Parliament

The role of independent expertise in legislative process

Testimony before the European Parliament Committee on the Internal Market and Consumer Protection (IMCO).

By: Zsolt Darvas and J. Scott Marcus Topic: European Macroeconomics & Governance, European Parliament, Testimonies Date: July 18, 2018
Read article

Blog Post

Germany’s savings banks: uniquely intertwined with local politics

German savings banks, known as Sparkassen, form an important feature of the country's banking assets. Unlike in other European countries, German Sparkassen also hold direct links with local political communities. This post focuses on the Sparkassen's structural links and relationships with elected politicians. Three findings which do not appear to have been specifically documented previously stand out.

By: Jonas Markgraf and Nicolas Véron Topic: European Macroeconomics & Governance, Finance & Financial Regulation Date: July 18, 2018
Read article More on this topic More by this author

Opinion

A Brexit deal is still not achieved

The UK paper should be seriously considered. While it breaks a number of European red-lines, it is also an attempt to solve some issues. The question is whether the EU will be ready to seriously negotiate. Geostrategic considerations suggest that it is time for the EU to do so.

By: Guntram B. Wolff Topic: European Macroeconomics & Governance Date: July 13, 2018
Read about event More on this topic

Past Event

Past Event

Designing a new institutional framework for UK-EU relations

Finding the right way forward for the EU and the UK.

Speakers: Raphael Hogarth, Jill Rutter and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: July 13, 2018
Read article More on this topic More by this author

Podcast

Podcast

Italy's economic and political outlook

In this week's Sound of Economics, Bruegel affiliate fellow, Silvia Merler, is joined by Marcello Minenna, PhD lecturer at the London Graduate School and Head of Quants at Consob, as well as Lorenzo Codogno, LSE visiting professor, to discuss the Italian government's economic outlook in the European context.

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: July 11, 2018
Load more posts