Three Questions on Monetary Tightening
Lorenzo Bini Smaghi
Member of Executive Board
of the
European Central Bank
Nomura conference
Tokyo, 26-27 October 2006

The views expressed reflect only those of the author. I wish to thank Livio Stracca for his help in preparing this
speech and Vincent Brousseau for his contribution to the Annex.
Introduction
In the last two years the central banks of the three major currencies have started to increase
interest rates again, after a prolonged period of low or decreasing rates.
The three experiences differ in many dimensions, in particular with respect to timing and pace.
The Federal Reserve started first, in June 2004, and since then rates have been raised by 425
basis points. The European Central Bank started in December 2005, with a 125 basis points
increase in less than one year. In Japan the process has just started, in July 2006, with a 25
basis points increase from the zero interest rate floor.
The three episodes have nevertheless some common features. In all cases the tightening cycle
started from a historically low level of interest rates, both in nominal and real terms. At the
starting point, the US Federal Fund rate was at 1 per cent in nominal terms and around -2 when
deflated by headline inflation. The ECB refinancing rate was at 2 per cent in nominal terms and
around zero in real terms. The Bank of Japan target for the overnight call rate was at zero both
in nominal and real terms.
The fact that the level of the nominal and real interest rate were rather low, compared to
historical levels and to underlying economic and monetary conditions (such as the growth of
nominal income and the output gap) suggests that at the start of the tightening cycle monetary
policy was quite expansionary. In other words, the initial level of the interest rate was
substantially below the so-called “neutral” level, which is the level of the interest rate that
ensures price stability for given underlying conditions, at least in the most plausible scenario.
Such a low level might have been warranted in the presence of sizeable downside risks, but
was unsustainable once these risks receded.
According to standard macroeconomic analysis, if the interest rate is systematically below its
“neutral” level monetary policy is expansionary and might ultimately fuel inflationary
pressures. Therefore, even if interest rate is raised but remains below the “neutral” level,
monetary conditions continue to be expansionary, although to a lesser degree.
On the basis of these considerations, it would appear that in spite of the recent interest rate
increases in the three largest areas monetary conditions have remained significantly
expansionary, as confirmed by the ample liquidity conditions prevailing at the global level.
Rather than a fully-fledged monetary tightening one should thus rather speak of a reduction in
the degree of monetary expansion.
In a tightening cycle central banks have to address three main questions: When to start
tightening? At what speed tighten? When to stop tightening?
2
I will try to examine these three questions in light of the most recent experience and taking into
account three main problems. First, an information problem: how to interpret incoming data to
assess and forecast economic developments so as to calibrate the appropriate interest rate
response. Second, an incentive (or perhaps I should say risk management) problem: how to
balance the risk of acting too early or being too late, i.e. being ahead or behind the curve. Third,
a communication problem: how to communicate policy decisions and intentions to the market
and the public, especially in light of uncertainty about underlying economic developments, to
promote predictability and safeguard the credibility of the central bank.
These challenges are not independent and may actually compound, as I shall discuss in more
detail later. Let’s examine the three questions in turn.
Let me clarify from the start that the purpose of these considerations is to try develop a
conceptual framework, based largely on the recent experience, rather than to provide
indications about future monetary policy developments, in particular for the euro area. Indeed,
the future might provide us with new insights, which have not been taken into account and that
might lead to a reconsideration of this analysis.
1. When to start tightening?
It is well known that monetary policy implies long and variable transmission lags and that the
lags are longer for inflation than for output. This implies that an optimal monetary policy
tightening should start some quarters ahead of the upswing. If we start from a situation of
negative excess demand, in which economic activity is lower than potential (negative output
gap), the expectation of output growing above potential (so that the output gap closes) should
trigger the start of tightening. If the central bank fails to increase interest rates at that point,
inflationary pressures might pile up.
An important corollary is that the start of the tightening cycle should not wait for headline
inflation to rise. The increase in interest rate, which as I mentioned previously initially entails
only a reduction in the degree of monetary expansion rather than an absolute tightening, has to
start before inflationary pressures materialise. It is aimed at ensuring that inflation does not rise
later on, when it is too late and more costly to bring inflation down.
The sooner interest rates are raised, as economic activity recovers, the less interest rates will
have to be increased later on to maintain price stability.
In implementing this strategy the central bank is faced with the three problems mentioned
previously.
3
Let me start with the information problem. It is very difficult to forecast the beginning of an
upswing, giving the uncertainties prevailing around turnarounds. According to some, this
problem should not be so serious. If the central bank has a simple linear-quadratic loss
function, uncertainty does not affect the optimality of the policy decision, ex-ante. The central
bank should thus use its best forecast as a basis for such a decision.1
The experience of the early 1970s confirms that hesitating for too long at the start of a
tightening cycle may be quite dangerous. Recent research has shown that the Great Inflation of
the 1970s may have originated from the combination of an information problem (the difficulty
of assessing the level of excess demand in real time2) and an incentive problem, due to the fact
that a tightening would have been politically costly at times of rising unemployment and
slowing output growth, especially in an intellectual environment in which the long-term link
between inflation and monetary policy was less than fully clear.3
Some might find it appropriate for the central bank to wait until there is clear evidence that
growth has picked up above potential and that the output gap has started to close before starting
to tighten. The risk of having possibly waited too long and having been behind the curve could
be reduced through an acceleration of the pace of tightening thereafter. However, as I have
indicated in a speech made in Berlin about one year ago, the risk of getting behind the curve
(what I then called “Type I” error) might further increase if the tightening starts at an interest
rate level that is substantially below the “neutral” level.4
One lesson that might be drawn from the recent tightening cycle is that the lower is the starting
point, in terms of interest rate level, the less a central bank can afford to wait to have
confirmation of the ongoing recovery before starting to tighten. To be sure, even if the central
bank might have some room to wait for data confirming the economic pick up, it should
certainly not wait for inflation to be on the rise to increase interest rates. This would clearly
imply falling behind the curve and having to correct more abruptly at a later stage with sharper
interest rate increases.
1
See for example Svensson and Woodford (2003).
2
See, for example, Orphanides and van Norden (2005).
3
Nelson (2004) provides a survey of the factors that motivated the macroeconomic policies that led to the Great
Inflation of the 1970s. The paper argues that the “monetary policy neglect” hypothesis – i.e. that policymakers
took a non-monetary view of the inflation process – is a satisfactory explanation which is consistent with (1) the
estimated monetary policy reaction function; (2) the timing patterns relating monetary policy developments and
inflation; and (3) the record of economic views, as manifested in statements by policymakers and financial
commentators. The output gap mis-measurement hypothesis, supplements the monetary policy neglect
hypothesis.
4
See Bini Smaghi (2006).
4
For the ECB, the monetary pillar of the strategy, which is based on the analysis of money and
credit aggregates, proved to be quite a useful complement to motivate the start of the monetary
tightening (or I should perhaps say the “normalisation” of monetary conditions) at the end of
2005. In addition to the staff projections that were pointing to an inflation rate above the ECB’s
definition of price stability over the whole forecasting horizon, the fast rate of growth of
monetary and credit aggregates in the course of the second half of 2005 provided an
independent confirmation that interest rates were extremely low in comparison to the
underlying fundamentals. Not taking into account these monetary developments would have
entailed a further risk of falling behind the curve, in an environment of very expansionary
monetary conditions.
A further challenge for the central bank is to explain the start of the tightening cycle to
financial markets and the public at large. Relying on economic forecasts alone might be
difficult as the timing and pace of economic recovery are generally subject to wide debate. In
addition, politicians and social partners tend to ask the usual question: “Why are you increasing
interest rates if there is no inflation?”
The obvious answer to the question is that what matters is not the current inflation rate but the
outlook for future price stability. However, given the uncertainties surrounding the assessment
of the cyclical position, the central bank might want to use a variety of arguments and
indicators to explain the reasons underlying the start of the tightening.
I have found that a useful tool to address the communication challenge is a simple comparison
between the prevailing real interest rate level and the rate of growth of real income. As I
mentioned previously, at the end of 2005 the real interest rate was close to zero in the euro
area, while the rate of growth of economic activity was progressively picking up, from a yearly
pace of around 1.5 per cent to 2 per cent. Even somebody with a basic economic background
would understand that under these conditions keeping interest rates unchanged, at around zero
in real terms, would have implied an increase in the degree of monetary expansion, which
would have not been compatible over time with price stability. The fast pace of monetary and
credit aggregates and the dynamics of asset prices confirmed that the prevailing level of interest
rate was very low and potentially jeopardising price stability.
2. How fast to tighten?
The second issue I would like to address is the speed of adjustment of policy rates once a
tightening process is initiated. This will of course depend inter alia on the strength of the
recovery, the level of the output gap, the starting position and the distance of the actual interest
rate from a plausible measure of its long-term equilibrium level. All these considerations will
5
obviously be surrounded by a great deal of uncertainty. On the other hand, there is generally a
lot of pressure on the central bank for it to be as explicit as possible on the foreseen interest rate
path.
How should central banks react to such a request? Should central banks communicate to the
market on how quickly they intend to bring the interest rate back to the equilibrium level
(assuming that they know what the equilibrium level is)?
There is an interesting degree of variation in central bank practices around the world. Some
central banks, notably the Reserve Bank of New Zealand (since 2000) and the Central Bank of
Norway (since 2005) have started to provide the public with a quantitative indication of the
most likely course of policy as part of their macroeconomic policy projections. Other central
banks, most notably the Federal Reserve, have provided a qualitative guidance on the likely
direction and pace of interest rate moves. The ECB has instead refrained from giving guidance
to market participants beyond the very short term (one to two months), leaving to the latter the
task of setting their own expectations.
In my view, the idea of giving markets explicit forward guidance has some advantages, but also
some drawbacks. Let me elaborate.
There are three possible advantages of giving forward guidance to the markets, beyond the very
short term. First, and most important, it may enhance the central bank leverage over long-term
interest rates and therefore increases the potency of monetary policy. This may not be a very
important consideration at all times, but it may become quite useful once the central bank faces
a significant risk of hitting the zero bound on nominal interest rates and if the private sector is
unsure about the likely monetary policy response under such conditions.5
The objective of increasing the effectiveness of monetary policy may be particularly important
if the central bank has previously fallen behind the curve and waited too long before increasing
interest rates. Under these circumstances, preannouncement may help anchoring market
expectations and avoid an increase in inflationary expectations. However, there is no guarantee
that forward guidance will work if used occasionally, as I will explain in a moment.
A second potential advantage is that forward guidance may provide observers with a better
understanding of the central bank reaction function. Since the projected interest rate path is
(quantitatively or qualitatively) dependent on the projected path of macroeconomic variables, a
revelation of the preferred path may give the market more explicit information on how the
central bank plans to react to certain (though hypothetical) developments. Interestingly enough,
5
See Adam and Billi (2006).
6
however, in Norway and New Zealand market interest rates have generally not always fully
aligned to the path projected by the central bank.
Finally, the necessity of giving the market some forward guidance automatically forces the
policy-making bodies to agree on a baseline scenario for the future. This may provide a useful
internal framework for discussion and favour a more structured and consistent communication
policy.
These are the advantages. But there are also drawbacks.
First, even when they are not intended to be so, there is a certain risk that the projected interest
rate path is interpreted by the markets as being as an unconditional commitment. This may
happen even when the central bank is careful in explaining that deviations of actual rates from
the projected path should be seen as the norm, rather than the exception, as is the case of the
Reserve Bank of New Zealand and the Central Bank of Norway. This is, in essence, a
communication challenge.
The problem is a serious one because the macroeconomic outlook might be subject to sizeable
and frequent changes, in particular following the release of new data.6 A central bank wishing
to communicate in a consistent way the path of future interest rates would need to release a new
path almost every month, or even more frequently, if it wants to be effective in its task of
guiding markets and to be fully transparent. We can observe that the market yield curve can at
times change quite significantly in a matter of weeks. For instance, the yield curve for the
implied expected overnight rate in the euro area shifted down quite a bit between mid-August
this year and mid-September.7 If a central bank decided to communicate its expected interest
rate path to guide the markets, it might have to do so with a very high frequency, at least on
occasions. That could be quite confusing for market participants.
The second problem, which has not been sufficiently debated in the literature but is, in my
opinion, quite important is that providing forward guidance to markets, at least to the extent to
which it is intended to steer longer-term interest rates, may be difficult and costly to
implement. Forward guidance is effective if it is credible, and in order to be credible, the
central bank has to deliver on past promises. Due to the unavoidable changes in the underlying
economic conditions (here we see again the information problem arising), there may be
occasions in which the central bank might have to deviate from its pre-announced path. In these
6
Reflecting the significant (and unavoidable) revisions in the growth and inflation outlook at horizons beyond a
few months, it is very difficult to forecast interest rates accurately. In the euro area, for example, market
expectations of future three-month interest rates one year out have been on average almost 1 full percentage point
off the mark over recent years (see Charts 1 and 2 in the Annex).
7
See Chart 3 in the Annex.
7
cases it might not be clear ex post whether the central bank is reneging on past promises or
simply reacting to newly available macroeconomic data in an optimal manner.
For a central bank that needs to establish its reputation, for instance because it might have
started the tightening cycle too late and have fallen behind the curve, there could be an
incentive to stick to the pre-announced path rather than trying to explain a deviation from it,
even if it is justified.
Third, and related to my previous point, a successful forward guidance may pre-empt private
sector expectations, reducing their information content. Rather than incorporating private
information, bond prices would simply reflect the views of the central bank. Pre-empting
private sector expectations of future interest rates would amount to restrict the information set
on which policy is based. This would make monetary policy less effective, exacerbating the
information problem.8 While it is difficult to quantify the loss, my sense is that it would not be
negligible.
Finally, the need of agreeing on a full path of future interest rates, and eventually updating it in
light of economic developments, might not be that easy, especially in a complex setting such as
the Eurosystem where the Governing Council is composed of eighteen (soon nineteen)
members. This consideration is especially important in a tightening cycle, when – as I
mentioned earlier – monetary policy decisions are subject to criticism and political resistance.
In such an environment, it has been suggested that taking a step at a time might be preferable
than agreeing on a grand strategy all at once.9 The relevance of this type of problem very much
depends on the institutional setting within and surrounding the central bank, which varies from
country to country.
The analytical tools used by central banks are also of some relevance here. Deciding on a path
for future interest rates is easier if the monetary policy is geared towards a single inflation
projection, as in an inflation targeting framework. The ECB’s monetary policy strategy
explicitly eschews the use of an all-encompassing model and is based on the systematic use of
available information under the two pillars of the strategy. It is naturally much more difficult
for this approach to be embedded in a one-dimensional model which automatically produces a
nice chart for the future path of interest rates, conditional to a path for inflation forecasts.
All in all, it can be questioned that a strategy aimed at providing markets with explicit forward
guidance has more advantages than drawbacks.
8
This point is still controversial. See Morris and Shin (2002) and its criticism by Woodford (2005).
9
See Goodhard (2001) and Mishkin (2004).
8
The experience of the ECB over the recent tightening cycle, which consists of giving guidance
only over the very short term (one to two months) but not pre-committing beyond that horizon
and basing rate decisions on underlying and projected economic developments has proved to be
quite successful and well received by the markets. In terms of market volatility beyond the very
short term, there seems to be no majors cost to be paid, as compared to strategies that are more
explicit on future interest rate path.10 For example, the degree of uncertainty perceived by
market participants on the future course of monetary policy, as measured by the implied
volatility on Euribor and Eurodollar futures contracts, is of the same order of magnitude in the
euro area as in the US. Furthermore, sufficient flexibility has been kept to adjust the pace of the
tightening to unexpected changes in the underlying economic conditions, moving in particular
from a three month to a two months frequency in the 25 basis points increase. Also, the
possibility has been used by the ECB to signal clearly to the markets when the prevailing
expectations did not coincide with its own assessment of the interest rate path, leading to an
immediate correction.
What is really important, in my opinion, to effectively guide financial markets is to
communicate very clearly the analytical framework of the central bank and how new
information and data are incorporated in the decision making. This should enable market
participants to derive their own expectation about the future path of interest rates. This strategy
might be more effective than pre-announcing the pace of the monetary tightening.
3. When to stop tightening?
This is in fact the most difficult question to answer, not only because downturns are difficult to
forecast but also because the cost of a policy mistake at that stage is higher and there is less
room to make up for it later on. Stopping too soon might unleash further inflationary pressures
as the economy starts weakening, thus reducing the room for cutting interest rates to
accommodate the slowdown. Stopping too late might worsen the economic downturn, with the
need to reverse rapidly the policy direction, undermining the credibility of the central bank.
The end of the tightening cycle should ideally anticipate the turn of the cyclical position of the
economy. If the economy grows above its potential and the output gap becomes positive,
keeping inflationary pressures and expectations under control could require that the interest rate
is increased above the long term equilibrium level.
10
See Brand, Buncic and Turunen (2006) for an analysis of the euro area yield curve and Gürkayanak, Sack and
Swanson (2005) for the US. Brand, Buncic and Turunen (2006) conduct a comparative analysis and show that
the impact of monetary policy decisions and communication on the yield curve is similar in the euro area and the
US.
9
The main difficulty at the peak of the cycle is to calibrate the level of interest rate in such a way
as to ensure price stability without affecting negatively economic growth.
I would like to focus in particular on two variables relevant in this assessment: the growth rate
of productivity and inflation expectations.
Over the cycle, the strengthening of productivity growth temporarily moderates firms’ marginal
costs, including labour costs, thus dampening inflationary pressure. One might conclude that as
long as productivity recovers there is a lesser need to adjust interest rates because inflationary
pressures are kept under control. This would be a wrong conclusion. Rising productivity
implies a higher level of the “neutral” interest rate. Keeping market rates unchanged while the
“neutral” rate rises implies, as we have seen previously, an expansion of monetary conditions
that will ultimately lead to higher inflation. To avoid this effect interest rates have to be
adjusted upwards, in line with the increase in the “neutral” rate. Hence, stronger productivity
growth might result in higher, not lower nor constant, interest rates. Put differently, increasing
productivity growth has a dampening effect on inflationary pressure only to the extent that the
interest rate is adjusted to take into account the increase in the “neutral” level.11
The reasoning is quite similar to that used in the through of the cycle to assess the
appropriateness of the interest rate level against nominal income growth, using a simple
monetary framework. As the economic recovery strengthens, and the negative output gap is
reduced or even tends to become positive, the level of the interest rate needs to be adjusted to
avoid monetary conditions becoming excessively expansionary.
The analysis has to consider both the price and real component of nominal income. For
instance, if inflation slows down, due to a fall in oil prices, but disposable income strengthens
following the improvement in the terms of trade, the pace of nominal income growth could
remain unchanged. This implies that the interest rate path should not be affected by the fall in
inflation, especially if temporary. This point is not easily appreciated by market participants
and observers, and thus implies some communication effort by central banks.
Another indicator that might be useful in guiding a central bank in the decision of when to stop
tightening is agents’ inflationary expectations. These indicators have to be used with some
caution. In particular, evidence of stable long-term inflation expectations, consistent with price
stability, do not necessarily imply that the monetary policy tightening can be stopped. There are
at least two reasons for this.
11
Chart 4 reports a measure of the real federal funds rate in the United States and of labour productivity growth. It
is evident from the chart that, for example, the real interest rate was higher in the second half of the 1990s in the
wake of the productivity growth acceleration, not lower, contrary to common opinion.
10
First, the analysis of data on inflation expectations is not straightforward since financial market
indicators (such as break even inflation extracted from inflation-linked bond yields) tends to
differ from, and be more reactive than expectations drawn from survey data. In the US, for
example, inflation expectations derived from bond yields fluctuated significantly over recent
years, while survey-based measures (such as those of the Philadelphia Fed Survey) have barely
moved at all. It is therefore not obvious which measure is most reliable.
Second, and most important, long term inflation expectations might remain low or even fall at
the peak of the cycle, but might rise again if headline inflation does not rapidly fall in parallel
with the slowdown of the economy. If this happens, it is then difficult (and costly for the real
economy) to bring expectations back to levels consistent with price stability. It might require
keeping rates at a significantly high level for some time. Indeed, experience suggests that
expectations have some intrinsic inertia and cannot be easily reversed. It is therefore better to
prevent an “inflation scare" from happening, and not be forced to react to it ex post. All in all, it
is important to monitor inflation expectations, but a central bank should not wait until they
move substantially before adjusting rates. Otherwise it may be too late and further tightening
might be needed to bring inflation expectations back to equilibrium.12
In practice, therefore, there is no reason to think that the monetary policy tightening should
necessarily stop at some long-term average level of interest rate (or any other empirical
measure of the natural interest rate). This will depend inter alia on the position of the economy
in the cycle, compared to its potential (output gap) and the persistence of inflationary pressures.
It is then not surprising that deciding the end of the tightening cycle is as difficult as the start, if
not more. The information problem is typically different at this stage, but no less challenging.
In addition to the uncertainty on the timing of the cyclical peak and the sustainability of the
recovery, there is an even greater one on whether the interest rate is at a level which may be
deemed compatible with the maintainance of price stability.
This is why the concept of “neutral” and long term equilibrium interest rates, while appealing
in theory, are very difficult to use in practice for the implementation of monetary policy. The
uncertainty surrounding the calculation of the “neutral” level of interest rate, in particular at the
peak of the cycle, makes this concept very difficult to be made operational.
There is by now a large body of literature on the real-time uncertainty surrounding the neutral
and natural level of interest rates.13 Some authors have suggested that central banks should
12
See Charts 5 and 6 in the Annex reporting break even inflation rates and the level of policy interest rates in the
euro area and the US. It is evident that a lot of dynamics in the policy rates is needed in order to stabilise break
even inflation rates.
13
See for example Laubach and Williams (2003).
11
concentrate on the changes in interest rates and forget about the level altogether, given the
measurement problems.14 It is certainly true that assessing the key components of the
equilibrium real interest rate, in particular productivity growth, is not easy and can lead to
persistent policy errors, even if the central bank behaves optimally. 15 In the euro area and in
other countries, we have seen persistent forecast errors in growth and inflation, but to date we
cannot be sure that such forecast errors derive from problems in measuring potential output
growth or from the effects of temporary shocks.
In practice, the end of the tightening cycle will have to remain dependent on the assessment of
the underlying and projected economic conditions. These conditions are subject to change,
following temporary or more permanent factors. It is thus very difficult to preannounce a given
interest rate level or a given policy attitude to be followed around the peak of the cycle. The
main guiding factor for interest rate adjustment has to remain the pursue of price stability over
the relevant horizon for monetary policy and the anchoring of inflationary expectations.
Conclusions
Let me conclude by trying to put forward some general lessons that might be learned from the
recent experience, which is clearly incomplete. These few comments are obviously non
exhaustive and very schematic. They are presented in a synthetic way and should be considered
as input for further discussion and reflection rather than providing any insight on future policy
actions.
To start tightening:

Don't wait too long, especially if the signs of recovery are apparent and interest rates
are at very low levels. The sooner tightening start, the less tightening might be needed
later on.

To be sure, don’t wait to see inflation rising before raising rates. It will be too late.

Use a wide set of indicators and arguments to explain to market participants and the
public at large why tightening is needed. Money and credit aggregates, asset prices and
the level of interest rates might be useful indicators of why the time has come to reduce
accommodation.
14
See Orphanides and Williams (2002).
15
The formal exposition of this argument is in Cukiermann and Lippi (2005).
12
While tightening:

If the strength of the recovery is uncertain, don’t feel compelled to commit to a given
path, even if the markets ask for it.

Keep enough flexibility to be able to accelerate or slow down the tightening, depending
on underlying economic conditions without appearing to change the underlying
strategy.

Use the same set of indicators mentioned above to explain why the pace of tightening
needs to be adapted.
At the end of the tightening:

Don’t preannounce when (and at what interest rate level) the tightening will be over,
but rather that it will depend on the development of the underlying fundamentals.

Be aware that if the tightening is ended too soon, interest rates might have to remain at
a high level for some time, even as the economy slows down.

Monitor inflation expectations carefully, but do not wait until they rise before
increasing interest rates.
All in all, independently of the state of the tightening cycle, it is always important that market
participants and the public at large have a clear understanding of the overall strategy that
underlies monetary policy and of the analytical framework that leads to policy decisions. They
should also understand the uncertainties underlying economic developments throughout the
cycle, that complicate the decision making process. Agents should ideally be able to forecast
the policy action of the central bank on the basis of the flow of information that they receive
and of their understanding of the central bank strategy. These are the foundation of a
predictable and credible monetary policy.
Thank you for your attention.
13
References
Adam, K. and R. Billi (2006): “Discretionary monetary policy and the zero lower bound on
nominal interest rates”, Journal of Monetary Economics, forthcoming.
Bini Smaghi, L. (2006): Economic Forecasting and Monetary Policy, Vierteljahrshefte des
DIW Berlin, 2/2006, pp. 54-64.
Brand, C. Buncic, D. and J. Turunen (2006): “The impact of ECB monetary policy decisions
and communication on the yield curve”, ECB Working Paper n. 657.
Cukierman, A. and F. Lippi (2005): "Endogenous monetary policy with unobserved potential
output," Journal of Economic Dynamics and Control, vol. 29(11), pp. 1951-1983.
Goodhart, C. A. E. (2001): “Monetary Transmission Lags and the Formulation of Policy
Decision on Interest Rates” Federal Reserve Bank of St. Louis Economic Review, July/August,
pp. 165-182.
Gürkayanak, R. S., Sack, B. and E. T. Swanson (2005): “Do action speak louder than words?
The response of asset prices to monetary policy actions and statements”, International Journal
of Central Banking, 1, pp. 55-93.
Laubach, T. and J. Williams (2003): “Measuring the Natural Rate of Interest”, Review of
Economics and Statistics, vol. 85(4), pp. 1063-1070.
Mishkin, F. (2004): “Can Central Bank Transparency Go Too Far?”, NBER Working Paper n.
10829.
Morris, S. and H.S. Shin (2002): “Social value of public information”, American Economic
Review, 92, 5, pp. 1521-1534.
14
Nelson, E. (2004): “The Great Inflation of the Seventies: What Really Happened?”, Federal
Reserve Bank of St. Louis Working Paper No. 2004-001A.
Orphanides, A. and S. van Norden (2005): "The Reliability of Inflation Forecasts Based on
Output Gap Estimates in Real Time," Journal of Money, Credit and Banking, vol. 37(3), pages
583-601.
Orphanides, A. and J. C. Williams (2002): "Robust Monetary Policy Rules with Unknown
Natural Rates", Brookings Papers on Economic Activity, 2:2002, pp. 63-118.
Svensson, L. E. O. and M. Woodford (2003): "Indicator variables for optimal policy," Journal
of Monetary Economics, Elsevier, vol. 50(3), pages 691-720.
Woodford, M. (2005): “Central Bank Communication and Policy Effectiveness”, NBER
Working Paper n. 11898.
15
Chart 1: Three-month realised Euribor interest rate and three-month rate
traded one year earlier implicit in the yield curve
6.0
5.5
5.0
4.5
4.0
3.5
3.0
2.5
2.0
Three-month rate traded one year earlier
Aug-06
May-06
Feb-06
Nov-05
Aug-05
May-05
Feb-05
Nov-04
Aug-04
May-04
Feb-04
Nov-03
Aug-03
May-03
Feb-03
Nov-02
Aug-02
May-02
Feb-02
Nov-01
Aug-01
May-01
Feb-01
Nov-00
Aug-00
May-00
Feb-00
1.5
Realised three-month rate
Source: Reuters and ECB calculations. The three-month rate traded one year ahead is derived
from forward rates implied in the yield curve of Euribor interbank interest rates. Absolute
values of this variable have to be interpreted with caution since there is no correction for term
premia. The realised three-month rate is based on the average of the EONIA rate over the
previous three months.
16
Chart 2: Standard deviation of market forecast errors for the Euribor threemonth interest rate, up to two years ahead
Standard deviation of forecast
error
2.2
1.7
1.2
0.7
0.2
-0.3 0
0.25
0.5
0.75
1
1.25
1.5
1.75
2
Time horizon
Source: Reuters and ECB calculations. The chart shows on the y axis the standard deviation as
derived from rolling zero-coupon maturities; on the x axis the forecast horizon. The forecast
errors are computed by approximating the forecast for the EONIA interbank interest rate from
the forward rates implicit in the Euribor yield curve at a given forecasting horizon, between one
day and 2 years. The chart reports the fitted standard error of the forecast as a function of the
forecasting horizon.
17
Chart 3: Implied forward overnight interest rates in the euro area (daily data
in percentages
5.0
5.0
15-Aug-06
4.0
4.0
15-Sep-06
9-Oct-06
5
D
ec
-1
4
D
ec
-1
3
D
ec
-1
2
D
ec
-1
1
D
ec
-1
0
D
ec
-1
9
D
ec
-0
8
D
ec
-0
7
-0
ec
D
-0
ec
D
-0
ec
D
6
3.0
5
3.0
Source: Reuters and ECB calculations.
18
Chart 4: Real short-term interest rate and productivity growth in the United
States, 1990-2005
6
5
4
3
2
1
0
-1
-2
1990
1993
1996
Annua l pro duc tivity gro wth
1999
200
200
R e a l fe de ra l funds ra te
Source: Federal Reserve System and Bureau of Labour Statistics. Productivity growth is
measured by the annual growth of output per hour worked. The federal funds rate is deflated
with the annual growth in the personal consumption deflator.
19
Chart 5: ECB’s minimum bid rate and break even inflation rate derived
from inflation-linked bonds
3.5
2.85
3.3
2.65
3.1
2.45
2.9
2.25
2.7
2.5
2.05
2.3
1.85
2.1
1.65
1.9
1.45
1.7
1.5
1.25
2
3
4
5
6
1
2
2
3
3
4
4
5
5
6
2
3
4
5
6
-0
-0 y-0 g-0 v-0 b-0 y-0 g-0 v-0 b-0 y-0 g-0 v-0 b-0 y-0 g-0 v-0 b-0 y-0 g-0
a
a
a
a
a
e
e
e
e
ov Feb
u
o
u
o
u
o
u
o
u
F
F
F
F
N
A
N
A
N
A
N
A
N
A
M
M
M
M
M
ECB minimum bid rate (left axis)
Break even inflation rate (right axis)
Source: Reuters and ECB.
20
Chart 6: Target for the federal funds rate and US break even inflation rate
derived from inflation-linked bonds
5.5
2.85
5
2.65
4.5
2.45
4
2.25
3.5
3
2.05
2.5
1.85
2
1.65
1.5
1.45
1
1.25
N
ov
-0
1
Fe
b0
M 2
ay
-0
A 2
ug
-0
N 2
ov
-0
2
Fe
b0
M 3
ay
-0
A 3
ug
-0
N 3
ov
-0
3
Fe
b0
M 4
ay
-0
A 4
ug
-0
N 4
ov
-0
4
Fe
b0
M 5
ay
-0
A 5
ug
-0
N 5
ov
-0
5
Fe
b0
M 6
ay
-0
A 6
ug
-0
6
0.5
Target for the federal funds rate (left axis)
Break even inflation rate (right axis)
Source: Reuters and ECB.
21