How the central banks' reaction function in SOE evolved during the crisis

The outbreak of the global financial crisis made the central banks to admit that keeping inflation within the target is not sufficient to stabilize the economy. Apart from price stability they should also care about financial and macroeconomic stability. To achieve this central banks should look not only at inflation but also at other variables. Economists agree broadly that inflation targeting framework should be realized in more flexible way in terms of both: paying more attention to output growth and allowing inflation to return to the target in longer horizon. The central bankers admitted that in some cases stabilizing the economy, may require inflation to deviate from the target for an extended period of time. This more flexible approach may be reflected in the modification of the way monetary policy is conducted and hence in the central banks' reaction function. The aim of this paper is to check empirically whether selected European central banks in small open economies outside the euro area, conducting autonomous monetary policy changed the way the monetary policy is conducted - whether central banks enhanced the flexibility of their inflation targeting strategy during the crisis. I investigate the reaction functions of the selected central banks using the ordered logit model to account for the unconventional monetary measures introduced by the central banks. The explanatory variables are the CPI and GDP growth forecasts published by four central banks in European small open economies which conduct autonomous monetary policy and are inflation targeters. The dependent variable is the change of the monetary policy stance reflected in changes of the policy rate and/or unconventional monetary policy measures. The results indicate that all analyzed banks have changed their way of setting interest rates, however in each case the change is different. The Czech central bank (CNB) extended the CPI forecast horizon which it takes into consideration when setting the interest rate. Additionally the its monetary stance became more accommodative. The Hungarian central bank (MNB) increased the weight put on the GDP growth after the outbreak of the global financial crisis. Similarly to the CNB, the MNB started to conduct more accommodative monetary policy. Although in the case of the Polish central bank (NBP) we do not observe changes of the forecast horizon, this bank also started to put more weight on the GDP growth forecast as compared to CPI forecast. Besides, the NBP's monetary policy has become more accommodative. In the case of the Swedish central bank, we do not observe an increase of the importance of the GDP growth, however there is an extension of the CPI forecast horizon which it takes into consideration when setting the interest rate. The results show that all the banks are ready to accept an extended period or larger deviations of inflation from the target in order to maintain the stability of the whole economy and become more flexible inflation targeters