Evaluation of the European Central Bank's reactions to the recent financial crisis within the two-pillar framework

Abstract

The main objective of this paper is to evaluate whether the European Central Bank has been consistent in its monetary policy approach during the recent extraordinary financial conditions. The evaluation is conducted within the ECB’s two-pillar framework. Both the central banks’ interest rate setting behaviour and their liquidity providing actions have been studied. The effectiveness of all these actions has been mostly left outside this paper’s focus.

The European Central Bank’s policy framework is based on the two-pillar framework, which includes very thorough monetary and economic analysis. Cross-checking the results from the analysis the ECB should maintain price stability in the euro area. This current study shows that the integration process still underway in the euro area limits the ECB’s pro-activity regarding extraordinary situations, as seen during the recent financial crisis.

The criticism laid on the ECB’s actions is found to be partly justified in a context of the interest rate setting, while the liquidity providing actions have closely followed those conducted by other major central banks. The interest rate level lowering has been relatively slow in the euro area, especially when compared to the US. This is found to result mostly from the consistency of the ECB’s policy, as well as misperceptions and forecast errors toward the evolution of the recent turmoil.

Empirical tests, which are loosely based on an earlier study by Gerlach (2004), further provide support to the consistency in the ECB’s actions. They also show that since the ECB has still reacted to changes in real economic variables, it is likely that since the recent changes have happened extraordinarily fast, the models used have not been able to efficiently predict the future outcomes.

Overall, the most significant limitations for the ECB’s policy framework, as well as for its flexibility and pro-activity in exceptional situations come through the disintegrated euro area. This makes the ECB’s responsibilities much less straight forward than those of a central bank acting within a single nation state.