Transcript Slide 1
The Zero Lower Bound, ECB Interest Rate Policy and the Financial Crisis Stefan Gerlach, IMFS, and John Lewis, DNB Introduction • CBs across the world responded to the financial crisis by cutting interest rates rapidly. • Two factors may have played a role: 1. Sharp deterioration of macro economic conditions. 2. Non-zero probability that the Zero Lower Bound (ZLB) would become a constraint. • Did the ZLB influence ECB’s interest rate setting? – Difficult know & competing explanations possible. – We argue that it probably did. © Stefan Gerlach 2 © Stefan Gerlach 3 © Stefan Gerlach 4 ZLB and Monetary Policy • ZLB rediscovered by Summers (1991) but seen as a curiosity of little practical relevance to MP. • The global decline in inflation in the late 1990s triggered much research on the ZLB. – Experiences of Japan. © Stefan Gerlach 5 • One can imagine three approaches to monetary policy in the vicinity of the ZLB. – Let i*= f(π, y, …) denote the “optimal” interest rate in the absence of the ZLB. – Normally, when i* >> 0, the CB’s policy problem is to determine i* and then sets i = i*. – When i* < 0, the ZLB binds. – Question is how does the CB set i as i* approaches 0? • First approach: – Set i = i* until the ZLB is reached and then set i = 0. © Stefan Gerlach 6 • Second approach: – Cut interest rates aggressively if the economy deteriorates and maintain them at this level longer (“extended period of time”) than implied by i*. • i < i* as the economy weakens. – Reifschneider and Williams (JMCB, 2000): • • • AD determined by long interest rates, which depend on the expected future path of short rates, i. By setting i < i* before and after the ZLB binds, CB might compensate for the fact i > i* when the ZLB binds. May be possible to achieve a long interest rate similar to that would have been observed if the ZLB had been irrelevant. © Stefan Gerlach 7 3. Third approach: – Keep the gun power dry. • – – Set i > i* so as to have more room to cut if needed. No formal model. Bini-Smaghi (2008): • • • Could worsen market sentiment. If rates are cut early, little room to cut rates if economy weakens further. Seems to disregard the fact that on “early” cut in i makes it less likely that i* turns negative. © Stefan Gerlach 8 Interest rates i i Time i* Our empirical approach • Unfortunately, i* is not observed. – Estimate reaction function (RF) that may shift during sample. • • • Use pre-crisis function to predict i during crisis and think of this as an estimate of i*. Involves predicting i in conditions very different from those in sample period. Gives us a sense of when, how rapidly and why the shift occurred. – Compare actual i with predicted i*. • Did ECB cut rates faster than implied by pre-crisis RF? © Stefan Gerlach 10 1. Switching as a function of time • Many ways to model the shift: – Piece-wise linear. • Assumes break instantaneous. – Markow switching. • Assenmacher-Wesche (EER 2006). – Smooth transition. • Mankiw, Miron and Weil (AER 1987). © Stefan Gerlach 11 Target level of interest rate: itT y yt t t t Gradual adjustment: it it 1 0 itT it 1 1it 1 et Reaction function: it ~ ~y yt ~ t ~ t ~ t ~iit 1 1it 1 et it Zt et © Stefan Gerlach 12 • Data choice: – Overnight rate rather than repo rate! • ON rates fell much below repo rate. • Reflects a policy choice, not an accident. – PMI rather than GAP. • Available with minimal lag. • Strongly correlated with y/y growth rate of real GDP. – HICP inflation. – M3. – Nominal effective exchange rate. © Stefan Gerlach 13 5 5 4 4 3 3 2 Repo rate Overnight rate 2 1 1 0 07M01 0 07M07 08M01 08M07 © Stefan Gerlach 09M01 09M07 14 .06 .04 60 PMI .02 50 .00 -.02 40 PMI Real GDP growth -.04 30 -.06 97 98 99 00 01 02 03 04 © Stefan Gerlach 05 06 07 08 Real GDP growth(y/y) 70 09 15 Equations for each regime: it I Zt et et ~ N 0, I2 it II Zt et et ~ N 0, II2 Composite equation: it 1 t I Zt tII Zt et Variance of errors: 1 t I2 t2 II2 2 2 Logistic transition: exp t t L , , t 1 exp t © Stefan Gerlach 16 1.0 1.0 0.8 0.8 0.6 0.6 12 months/k = 0.18 6 months/k = 0.37 3 months/k = 0.73 0.4 0.4 0.2 0.2 0.0 0.0 100 10 20 30 40 50 60 © Stefan Gerlach 70 80 90 17 © Stefan Gerlach 18 © Stefan Gerlach 19 © Stefan Gerlach 20 Figure 4 1.0 1.0 0.8 0.8 0.6 0.6 Median 0.4 0.4 0.2 0.2 0.0 07M01 0.0 07M07 08M01 08M07 © Stefan Gerlach 09M01 09M07 21 Figure 5 5 5 4 4 3 3 Overnight rate Median 2 2 1 1 0 07M01 0 07M07 08M01 08M07 09M01 09M07 One-step-ahead (static) forecasts, conditional on estimated switch. © Stefan Gerlach 22 Figure 6 5 5 4 4 3 3 Overnight rate Median 2 2 1 1 0 07M01 0 07M07 08M01 08M07 09M01 09M07 Dynamic forecasts, conditional on realised values of regressors and assuming no switch. © Stefan Gerlach 23 Summary of 1st set of results • Evidence that the reaction function shifted. • Interest rates were much below those predicted by the pre-crisis reaction function. • Compatible with the idea that ECB worried about ZLB. • Problems: – No explanation for shift; only estimates of when it and how fast it occurred. – Return to pre-crisis reaction function not possible. © Stefan Gerlach 24 2. Switching and economic conditions • Allow for switch as a function of state of the economy. – Real GDP growth over 12 months, g. – Interpolated. expg t g t L, g t , g 1 expg t g © Stefan Gerlach 25 © Stefan Gerlach 26 Figure 7 1.0 1.0 0.8 0.8 0.6 0.6 Median 0.4 0.4 0.2 0.2 0.0 07M01 0.0 07M07 08M01 08M07 © Stefan Gerlach 09M01 09M07 27 Figure 8 5 5 4 4 3 3 Overnight rate Median 2 2 1 1 0 07M01 0 07M07 08M01 08M07 © Stefan Gerlach 09M01 09M07 28 Figure 9 5 5 4 4 3 3 2 Overnight rate Median 2 1 1 0 07M01 0 07M07 08M01 08M07 © Stefan Gerlach 09M01 09M07 29 Conclusions • The ECB’s RF shifted during the financial crisis at around the time of the collapse of Lehmann. – Real economic activity drove change. • Out finding are compatible with ZLB literature. – Dynamic forecasts point small probability of i* < 0. • Competing explanations possible: – Orphanides (2010) suggests that a RF for the ECB that uses forecasts as RHS is stable and predicts interest rate setting also during the crisis. © Stefan Gerlach 30