Financial instability and ECB monetary policy

This paper proposes an assessment of the monetary policy performed by the European Central Bank (ECB) and, more specifically this paper investigates to what extent the ECB monetary policy decisions were guided by financial instability signals. Our assessment is achieved by estimating a Taylor's rule, augmented by financial instability aggregate indicators. This estimate enables us, on the one hand, to compare the fitted model predictions against the observed interest rate and, on the other hand, to decompose the setup of the key rate based on these different determinants. Using a sample of data related to the Euro area, we show that financial and banking instability impact on the key interest rate setup. Consideration of instability indicators brings forward a clear improvement of the Taylor's rule, mainly for the second period of the sample. This is because, at the beginning of the ECB, instability counted for one third of the explanation of the interest rate rule, and over the recent period (starting with the last quarter of 2005, up to 2009), for more than 54%.