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 article More on this topic More by this author

Blog Post

The international effects of ECB’s monetary policy

What’s at stake: the literature on monetary policy spillovers is abundant of studies investigating the impact of the US Federal Reserve’s monetary policy announcements and actions on emerging market economies. More recently, economists have been investigating the effect of the ECB’s credit easing as well.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: July 24, 2017
Read about event More on this topic

Past Event

Past Event

Perspectives on Universal Basic Income

At this event, we discussed the possible benefits but also the possible disadvantages of Universal Basic Income.

Speakers: Grégory Claeys, Olli Kangas, Professor Philippe Van Parijs and Prof. Dr. Hilmar Schneider Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: July 12, 2017
Read article More on this topic More by this author

Blog Post

The forward guidance paradox

What’s at stake: the term “forward guidance” is used in economic jargon to describe central bank communications about the likely future path of policy rates. Standard monetary models imply that far future forward guidance has huge effects on current outcomes, and recent literature has been trying to reconcile this with reality.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: July 10, 2017
Read about event

Upcoming Event

Sep
7-8
09:00

Bruegel Annual Meetings 2017

The Annual Meetings are Bruegel’s flagship event. They offer a mixture of large public debates and small private sessions about key issues in European and global economics. In a series of high-level discussions, Bruegel’s scholars, members and stakeholders will address the economic policy challenges facing Europe.

Speakers: José Antonio Álvarez Álvarez, Agnès Bénassy-Quéré, Pervenche Béres, Jean Luc Demarty, Anna Ekström, Lowri Evans, Sandro Gozi, Peter Grünenfelder, Patrick Graichen, Reiner Hoffman, Levin Holle, Steffen Kampeter, Peter Kažimír, Emmanuel Lagarrigue, Steven Maijoor, Nathalie Moll, James Murray, Carlos Sallé Alonso, André Sapir, Dirk Schoenmaker, Mateusz Szczurek, Marianne Thyssen, Liviu Voinea, Johan Van Overtveldt, James Waterworth, Ida Wolden Bache and Guntram B. Wolff Topic: Energy & Climate, European Macroeconomics & Governance, Finance & Financial Regulation, Global Economics & Governance, Innovation & Competition Policy Location: Square - Brussels Meeting Centre
Read about event

Past Event

Past Event

Is there a way out of non-performing loans in Europe?

At this event we looked at the issue of non-performing loans in Europe. The event also saw the launch of the latest issue of "European Economy – Banks, Regulation and the Real Sector."

Speakers: Emilios Avgouleas, Giorgio Barba Navaretti, Giacomo Calzolari, Maria Demertzis, Martin Hellwig, Helen Louri and Laura von Daniels Topic: European Macroeconomics & Governance, Finance & Financial Regulation Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: July 6, 2017
Read article Download PDF More on this topic

External Publication

Review of EU-third country cooperation on policies falling within the ITRE domain in relation to Brexit

What is the possible future relationship between the EU and the UK in light of Brexit? The report provides a critical assessment of the implications of existing models of cooperation between third countries and the European Union on energy, electronic communications, research policy and small business policy.

By: J. Scott Marcus, Georgios Petropoulos, André Sapir, Simone Tagliapietra, Alessio Terzi, Reinhilde Veugelers and Georg Zachmann Topic: European Macroeconomics & Governance Date: July 5, 2017
Read about event

Upcoming Event

Sep
28
12:30

Unfinished business: The unexplored causes of the financial crisis and the lessons yet to be learned

At this event Tamim Bayoumi will present his upcoming book on the financial crisis, showing how how the Euro crisis and U.S. housing crash were, in fact, parasitically intertwined.

Speakers: Tamim Bayoumi, Maria Demertzis and Aerdt Houben Topic: European Macroeconomics & Governance, Global Economics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More on this topic More by this author

Blog Post

Eurozone or EU budget? Confronting a complex political question

This week’s European Commission reflection paper is the latest document to ponder a distinction between EU and euro-area budgets. But do we need to split the two, and what would each budget be used for? In this post, I present an analytical framework for assessing this ultimately political question

By: Guntram B. Wolff Topic: European Macroeconomics & Governance Date: June 29, 2017
Read article More on this topic More by this author

Blog Post

Raising the inflation target: a question of robustness

In an unexpected move, the Federal Reserve Chair Janet Yellen has recently brought up the issue of raising the inflation target. This blog argues that an increase in inflation targets may prove to be beneficial in achieving price stability in the long run. This would increase the credibility of central banks in achieving inflation goals and stave off the distortionary effects of deflation.

By: Maria Demertzis Topic: European Macroeconomics & Governance Date: June 22, 2017
Read article More on this topic

Blog Post

Can EU actors keep using common law after Brexit?

English common law is the choice of law for financial contracts, even for parties in EU members with civil law systems. This creates a lucrative legal sector in the UK, but Brexit could make UK court decisions difficult to enforce in the EU. Parties will be able to continue using English common law after Brexit, but how will these contracts be enforced? Some continental courts are preparing to make judicial decisions on common law cases in the English language.

By: Uuriintuya Batsaikhan and Dirk Schoenmaker Topic: European Macroeconomics & Governance Date: June 22, 2017
Read article More on this topic More by this author

Blog Post

The size and location of Europe’s defence industry

There is growing debate about a common European military policy and defence spending. Such moves would have major economic implications. We look at the supply side and summarise some key facts about the European defence sector: its size, structure, and ability to meet a possibly increased demand from EU member states.

By: Alexander Roth Topic: European Macroeconomics & Governance Date: June 22, 2017
Read article More by this author

Parliamentary Testimony

House of Commons

Exiting the European Union Committee

On 19 April 2017 Zsolt Darvas appeared as a witness at the Exiting the European Union Committee, the House of Commons, United Kingdom.

By: Zsolt Darvas Topic: European Macroeconomics & Governance, House of Commons, Testimonies Date: June 20, 2017
Load more posts