Abstract:
The purpose is to investigate how the European Central Bank (ECB) sets interest
rates in the context of both linear and nonlinear policy reaction functions. It
contributes to the current debate on central banks having additional objectives over
and above 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
witnesses a shift from inflation targeting to output stabilisation and a shift, from an
asymmetric policy response to financial conditions at high inflation rates, to a more
symmetric response irrespectively of the state of inflation. Finally, guidance is
provided about models to forecast interest rates in the Eurozone area. Without
imposing an a priori choice of parametric functional form, semiparametric models
and autoregressive processes forecast out-of-sample ECB interest rate setting
behaviour better than linear and nonlinear Taylor rule models.
