European Economic Perspectives 30

As good as Greenspan

In 2001 a sharp deterioration in the economic outlook, both globally and in the Euro Area, gave the European Central Bank (ECB) its sternest test to date: steeply falling output was accompanied by rising inflation. Critics argued that because the ECB was overly concerned with maintaining price stability, it cut interest rates both too little and too late. Does such criticism stand up to scrutiny?

Written by a team of distinguished monetary economists, Monitoring the European Central Bank 4: Surviving the Slowdown, examines the simultaneous slowdown faced by OECD countries and identifies four reasons that made this situation especially challenging for the ECB. First, since all countries experienced simultaneous slowdown, no country was available as an external locomotive of growth to help out the others. Second, over-investment in the tech bubble left an overhang of capital, making new investment potentially unresponsive to interest rate cuts in the short run. Third, the end of the first inflation-less boom for decades raised the remote possibility that subsequent interest rate reductions might hit the zero lower bound before any danger of deflation had been completely averted. Fourth, uncertainty increased, at least temporarily, because of the events of September 11. 

The Fed responded by cutting interest rates aggressively. The ECB was slower to start cutting rates, and in total cut only a third as much as the Fed during 2001. Did the Fed cut too much or the ECB too little? Or were both responses entirely appropriate reflections of transatlantic circumstances that had differences as well as commonalities?

The authors of the CEPR Report argue that those calling for the ECB to acknowledge a more active concern for output in the short run must recognize that for half its life to date the ECB has allowed inflation to exceed 2.0%, the upper bound of the target range. As credibility grows, the ECB can in principle, support output without undermining its clear commitment to price stability. 

When judged by its past behaviour, the ECB was slow to cut interest rates in the first half of 2001, but by October had largely made up the lost ground. As noted in previous Monitoring the European Central Bank reports, however, the authors find the first pillar of the monetary strategy to be flawed beyond repair, both theoretically and empirically. Continuing to give money a special role in inflation forecasting will only serve to undermine ECB credibility unnecessarily.

Surviving the Slowdown also argues that the ECB should clarify which circumstances are grounds for international coordination and which are not. The fact that the ECB has already participated in coordinated activities with other leading central banks, notably in the aftermath of September 11, underlines the importance of establishing such a framework.

How would a Fed-in-Frankfurt have behaved? The Report uses the vector autoregressive (VAR) approach to examine how changes in policy that were previously unanticipated are then transmitted to macroeconomic variables. It also extracts information from the term structure of interest rates and estimates Taylor rules for monetary policy. The main finding of this analysis is that US interest rates were cut much further because the US faced a much bigger shock, not because the Fed and the ECB reacted very differently to the same circumstances. 

Overall the authors support the view that until it has a longer track record of success, a clearer admission of its multi-dimensional mandate, and spends less time explaining away uninformative or perverse monetary indicators, it will be hard for the ECB to change interest rates much in advance of events, even though monetary policy takes time to work its magic.

Download PDF

 
Return to contents

 
Browse Archives