Monetary policy stress in EMU during the moderation and the global crisis

This paper re-examines the problem of monetary policy stress in the EMU, both prior to the crisis as well as after its outbreak. It aims to (firstly) reconfirm that monetary policy during the great moderation (i.e. until late 2008) was responsible for fuelling the process of imbalance accumulation in the EMU, and (secondly) to determine to what extent the stress was caused by macroeconomic divergences. We employ a forward-looking Taylor-type monetary policy reaction function with realtime forecasted data to mimic the ECB monetary policy during the great moderation. The estimated coefficients are subsequently used to create counterfactual series of ruleconsistent country-specific interest rates and compute monetary policy stress in EMU individual member states. The results confirm that peripheral countries were exposed to risks emerging from excessively low interest rates, while the “core” countries had to live with too-high interest rates, and the stress was generally stronger in the former case. Interestingly, the bulk of it was non-fundamental, i.e. not caused by inflation and output gap differentials between countries. There are several potential sources of this stress and we show that missed forecasts were making an important contribution and they were mainly responsible for pushing the interest rate below its rule-consistent level.