Financial conditions and nonlinearities in the European Central Bank (ECB)

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.