ECB monetary policy in the presence of nonlinearities

Abstract

The recent financial crisis of 2007-2009 raises several issues related to the conduct ofmonetary policy during the last two decades. Inflation targeting monetary strategy hasbeen pointed as a potential source of the crisis, as its main objective of inflationstabilization might have diverted central banks from financial stability. We considerthe case of ECB inflation targeting monetary policy since its inception in order toprovide evidence of possible changes in its implementation after the collapse ofLehman Brothers in September 15, 2008. To this end we take into consideration theexistence of nonlinearities that may exist in the estimated Taylor rule specification.We employ three alternative econometric approaches: (a) The Qu and Peron (2007)structural break model; (b) a TVP model with stochastic model and (c) a Markov-Switching VAR model using quarterly data for the ECB for the period 2001:Q1 to2012:Q4. The main findings of our analysis show that the recent financial turmoil andthe debt crisis had not led the ECB to a stronger response to inflation in its reactionfunction and debt crisis. From a theoretical and policy perspective our findings implythat the ECB could stabilize inflation without adopting a more aggressive set ofmonetary rules to combat increased inflation changes.