Monetary Policy Inertia Held Back Growth In The Euro Area

Gradual changes in the in?ation target have played a major role in the euro area business cycle, according to research by Patrick Fève, Julien Matheron and Jean-Guillaume Sahuc, published in the September 2010 Economic Journal. Their counterfactual exercises show that, had monetary policy implemented its new in?ation objective at a faster rate, the euro zone would have experienced more sustained growth than it actually did.

Inflation in the euro area fell dramatically from 12% in the early 1980s to 4% in the early 1990s. In spite of some differences, inflation rates in most member countries displayed a very gradual downward trend over this period. At the same time, these economies experienced protracted periods of recessions.

These dynamics followed purposeful monetary policies aimed at stabilising inflation at lower levels. This study addresses two questions: did permanent and gradual changes in monetary policy significantly affect euro area countries over the past decades; and if so, through which channels did these shocks propagate?

Two classic channels have been considered in the research literature: (i) excessive and persistent real wages; and (ii) persistently high real interest rates. Both are embedded in the analysis of this research. The authors use state-of-the-art modelling and econometric techniques to disentangle the respective roles of each suspect and the channels through which they contributed to propagate inflation target shocks.

They find that the main force accounting for the recessionary effects of disinflation shocks is the inertial behaviour of monetary policy, in the form of both gradual disinflation shocks and an inertial interest rate rule. These two features turn out to imply very long lasting increases in the real interest rate, which translated into persistent output losses throughout the 1980s.

Had monetary policy implemented its new inflation objective at a faster rate, the euro area would have experienced more sustained growth than it actually did during this period. Surprisingly, the researchers find that the dynamics of GDP would have been very similar either if no disinflation occurred at all or if actual disinflation had been conducted at a much faster pace. Under both counterfactual scenarios, the output loss would have been cut by two.

”Inflation Target Shocks and Monetary Policy Inertia in the Euro Area” by Patrick Fève, Julien Matheron and Jean-Guillaume Sahuc is published in the September 2010 issue of the Economic Journal.