The Dynamic Adjustment Of Central Banks’ Target Interest Rate: The Case Of The Ecb

A fundamental aspect of the ECB’s monetary policy is that it aims to pursue price stability “over the medium term.” However, the ECB has not defined the medium term with reference to a predetermined horizon, retaining some flexibility with regard to the exact time frame. The objective of this paper is to shed some light on how the horizon of price stability is being achieved in practice, in a context where the ECB faces convex and non-convex costs of adjusting the target interest rate. We assume that ECB’s monetary policy follows an average flexible inflation target framework, and we analyse the R2 of an equation where the target interest rate is specified as a function of the j-period window over which average inflation rate is measured. Target interest rate inertia is incorporate through a switching interest rate equation based on the play model of hysteresis. We have found that the ECB is targeting the key interest rate over a seven years window, implying that the ECB is following a hybrid approach to price stability in line with average inflation target. We also have found hysteresis effects in the dynamic adjustment of ECB´s target interest rate.