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Financial conditions and nonlinearities in the European Central Bank (ECB) reaction function: In-sample and out-of-sample assessment

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  • Milas, Costas
  • Naraidoo, Ruthira

Abstract

Our purpose is to investigate how the European Central Bank (ECB) sets interest rates in the context of both linear and nonlinear policy reaction functions. This work contributes to the current debate on central banks having additional objectives over and above control of inflation and output. Three findings emerge. First, the ECB takes financial conditions into account when setting interest rates. Second, amongst Taylor rule models, linear and nonlinear models are empirically indistinguishable within sample, and model specifications with real-time data provide the best description of in-sample ECB interest rate setting behaviour. Third, the 2007-2009 financial crisis witnessed a shift from inflation targeting to output stabilization, and a shift from an asymmetric policy response to financial conditions at high inflation rates to a more symmetric response regardless of the state of inflation. Finally, guidance is provided as regards models for forecasting interest rates in the Eurozone area. Without imposing an a priori choice of the parametric functional form, semiparametric models and autoregressive processes forecast the out-of-sample ECB interest rate setting behaviour better than linear and nonlinear Taylor rule models.

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Bibliographic Info

Article provided by Elsevier in its journal Computational Statistics & Data Analysis.

Volume (Year): 56 (2012)
Issue (Month): 1 (January)
Pages: 173-189

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Handle: RePEc:eee:csdana:v:56:y:2012:i:1:p:173-189

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Web page: http://www.elsevier.com/locate/csda

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Keywords: Monetary policy Nonlinearity Real-time data Financial conditions;

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Cited by:
  1. Bergmeir, Christoph & Costantini, Mauro & Benítez, José M., 2014. "On the usefulness of cross-validation for directional forecast evaluation," Computational Statistics & Data Analysis, Elsevier, vol. 76(C), pages 132-143.
  2. John Ashton & Andros Gregoriou, 2012. "The Influence of Banking Centralisation on Depositors: Regional Heterogeneities in the Transmission of Monetary Policy," Working Papers 12005, Bangor Business School, Prifysgol Bangor University (Cymru / Wales).

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