Taylor Rule for Euro-core and Euro-periphery: Does it fit?

Fernanda Nechio of FRBSF has this amazing and timely research on the issue. It estimates Taylor rule for Euroarea as a whole and then calculates it separately for Euro-core and Euro-periphery economies. Needless to say, one size does not fit all.

The paper responds to the recent ECB rate hike in Apr-11 and one more expected in July. Are these rate hikes in line with Taylor Rule?

Figure 1A compares policy rates recommended by the Taylor rule for the euro area over time with the actual target rates set by the ECB. It shows that, since 2005, the actual target rate has generally closely matched the rate recommended by the Taylor rule. In particular, the ECB’s recent policy rate increase was in line with the Taylor rule recommendation.

But then we know it is 17 economies which form the union. How about all 17? Thier is marked difference between the dofferent economies.

Figure 2 shows core inflation rates and unemployment gaps for selected euro-area countries, along with their relative size in the area. The figure illustrates a marked divergence between the peripheral countries of Greece, Ireland, Portugal, and Spain and the so-called core European countries of Austria, Belgium, France, Finland, Germany, and the Netherlands. Germany’s economy is booming, while Spain has an unemployment gap of almost 8 percentage points. Overall, the peripheral countries have much higher unemployment gaps than the core countries. At the same time, inflation varies significantly in the peripheral countries

To simplify she estimates Taylor Rule for Euro-core (Germany, France etc)  and Euro-periphery (Greece, Spain etc).

Figure 3 compares the paths of rates recommended by the Taylor rule for the euro area’s core and periphery with the actual ECB policy target rate. As noted earlier, the ECB’s actual target rate seems to be in line with the Taylor rule recommendation for the euro area as a whole. But things look very different when the Taylor rule is applied separately to the euro area’s core and periphery.

The policy target rate recommended by the Taylor rule for the peripheral countries remains negative. The ECB’s actual policy rate is well above the rate recommended by the Taylor rule for the periphery, but below the Taylor rule recommendation for the core. This is not surprising.

The core countries are well along the path of economic recovery. But the peripheral countries are still struggling to recover from the sovereign debt crisis. They are implementing a range of reforms and fiscal adjustments, which have impeded overall economic recovery (see Nechio 2011). It is uncertain whether the peripheral countries will be able to grow fast enough to generate the income they need to service their sovereign debt obligations. Increases in interest rates may make reaching such growth levels even more challenging.

This is on expected lines. That is what most EU-sceptic economists say as well.

If these 17 economies had independent monetary policy, periphery central banks would have kept rates near zero and further would have expanded their balance sheets to provide more stimulus as rates cannot become negative (many economists like Mankiw, Buiter disagree negative rates matter).

If one looks at the graph, ECB policy is more stimulating for EU-core as of now. It should be around 2.5% compared to 1.25% currently.

The author points ECB policy was more stimulating before the crisis.

Strikingly, Figure 3 shows that a divergence between the ECB’s actual target rate and the rate recommended by the Taylor rule for the peripheral countries is not new, but has reversed itself. Before the 2008 crisis, the ECB target rate lay below the level predicted by the Taylor rule for the peripheral countries. In fact, from the inception of the euro to the 2008 financial crisis, the actual ECB policy rate was below the rate predicted by the Taylor rule for the peripheral countries and more in line with Taylor rule recommendations for the core euro-area countries. During the financial crisis in 2008, the peripheral countries fell into deep recession, which was followed by a debt crisis from which they have yet to recover. By contrast, recovery in the euro-area core has been more robust. These events reversed the historic pattern and positioned the ECB policy rate above the Taylor rule recommendation for the peripheral countries.

This lower rate fuelled the huge boom in peripheries before it burst..

Clearly not one size fits all. The author says same is for US as well but it has more options:

The euro area’s problem of a “one-size-fits-all” monetary policy is not unique. In the United States, economic conditions have frequently differed dramatically across regions. The Federal Reserve does not set different monetary policies for different parts of the country. Nevertheless, the tensions over monetary policy in a union of many separate countries are likely to be greater than tensions in a single country. The United States can rely on its relatively high labor mobility and on fiscal policy to counter economic weakness, for example, options that may not be fully available to the euro area’s heavily indebted peripheral countries.

We have known these differences, nice to read a paper showing all this empirically and very simply.

Bini Smaghi of ECB had a speech of the same title:

In sum, I would maintain that there are no clear reasons for believing that cross-country variation in economic performance within the euro area has proved larger than would have been the case if national monetary policies had been retained and the euro not introduced. But, at the same time, I do not think that cross-country differences in Monetary Union, which raise the potential for persistent divergence of economic performance, can or should be ignored.

Looking forward, the financial crisis and its impact on the functioning of financial markets in some countries has led to a situation in which cross-country heterogeneity owing to differences in monetary policy transmission may be more pronounced than before the crisis – at least if effective remedial measures are not taken.



He says ECB has both standard and non-standard measures. Non-standard measures includes buying G-sec bonds under ECB’s Securities Markets Programme. Smaghi says these bonds should be bought only if IMF/EU restructuring program is followed properly. He asserts for a single monetary policy to work well, fiscal and government policies need to be focused as well. 




One Response to “Taylor Rule for Euro-core and Euro-periphery: Does it fit?”

  1. One size fit monetary policy for US?? « Mostly Economics Says:

    […] seems to be a US vs Euro blogposts day. I covered a paper from Fernando Nechio which looked at one size fit monetary policy for Europe. The paper divided […]

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