DP8472 ECB Reaction Functions and the Crisis of 2008

Author(s): Stefan Gerlach, John Lewis
Publication Date: July 2011
Keyword(s): ECB, reaction functions, smooth transition, zero lower bound
JEL(s): C2, E52
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=8472

We study ECB?s interest rate setting in 1999-2010 using a reaction function in which forecasts of future economic growth and inflation enter as regressors. Allowing for a gradual switch between two reaction functions, we detect a shift after Lehman Brothers failed in September 2008 when the pre-crisis reaction function first indicates that interest rates may become constrained by the zero lower bound. Furthermore, the interest rate cuts in late 2008 were more aggressive than forecast by the pre-crisis reaction function. These findings are compatible with the literature on optimal monetary policy in the presence of a zero lower bound.