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Interest Rate Setting by the ECB, 1999–2006: Words and Deeds ∗

Under Article 22n paragraph 1 of the Austrian Banking Act, all positions in fi nancial instruments and commodities held for trading purposes are to be assigned to the trading book. Likewise, fi nancial instruments and commodi- ties used to hedge or refi nance specifi c risks in the trading book are also to be assigned to the trading book. To cover the market risks arising from the trading book, credit institutions must retain a minimum amount of capital, as was already laid down in the Basel paper on market risk entitled “Amendment to the Capital Accord to Incorporate Market Risks”. | Interest Rate Setting by the ECB 1999-2006 Words and Deeds Stefan Gerlach Institute for Monetary and Financial Stability Johann Wolfgang Goethe University Frankfurt am Main We estimate empirical reaction functions for the European Central Bank ECB with ordered-probit techniques using the ECB s Monthly Bulletin to guide the choice of variables. The results show that policy reacts to the state of the real economy M3 growth and exchange rate changes but not to inflation. We develop quantitative indicators of the Governing Council s assessment of economic conditions to understand its interest rate decisions and argue that the ECB has not reacted to inflation shocks because they were seen as temporary. By contrast policy responses to economic activity are strong because it impacts on the outlook for inflation. JEL Codes E43 E52 E58. 1. Introduction A number of authors have studied the interest-rate-setting behavior of the Governing Council of the European Central Bank ECB by estimating empirical reaction functions.1 However it is unclear I am grateful to participants at the 2005 Konstanz Seminar and the Second HKIMR Summer Workshop in particular my discussants Klaus Adam and Corrinne Ho to participants at seminars at the Austrian National Bank the Bank for International Settlements the Bundesbank the European Central Bank De Nederlandsche Bank and the University of Frankfurt and to Katrin Assenmacher Michael Chui Hans Genberg Petra Gerlach Edi Hochreiter Paul Mizen John Taylor and Cees Ullersma for comments. E-mail stefan. gerlach@wiwi.uni-frankfurt.de. The literature estimating reaction functions has grown too large to survey here. See Berger de Haan and Sturm 2006 and Carstensen 2006 for recent contributions. The working paper version of this paper Gerlach 2004 contains a review of the early literature on estimating empirical reaction functions on euro-area data. 1 2 International Journal of Central Banking September 2007 whether studies that focus solely on the ECB s