Monetary Policy in the United States, the Euro Area, and Japan

By Rocheteau, Guillaume; Tinlin, Bethany | Economic Trends, May 2007 | Go to article overview

Monetary Policy in the United States, the Euro Area, and Japan


Rocheteau, Guillaume, Tinlin, Bethany, Economic Trends


05.01.07

The conduct of monetary policy typically depends on specific economic conditions within a country such as its inflation, its level of production, and its level of employment. It also depends on the mandate of its central bank and the bank's objectives in terms of price stability, employment, and growth (among other things). For instance, the European Central Bank pursues price stability as its primary goal, while the Federal Reserve System seeks maximum employment, stable prices, and moderate long-term interest rates, q-he Bank of Japan aims for price stability and for the stability of the payments and settlement system. Thus, in principle, different countries should be expected to run different monetary policies. But when we focus on the United States, the Euro area, and Japan, we see that while monetary policies differ across those countries, some general patterns in their approaches can be identified.

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Policy Instruments: Overnight Rates

To achieve their objectives, central banks set overnight interest rates: the federal funds rate in the U.S., the minimum bid rate in the Euro area, and the uncollateralized overnight call rate in Japan.

Since 2000, interest rates have followed a somewhat similar pattern in the US and the Euro area: they declined substantially from 2001 to 2004 and gradually increased after 2004 (U.S.) or 2005 (Euro area). The amplitude of the changes has been higher in the U.S. than in Europe. In contrast, overnight rates in Japan remained close to 0 percent, the minimum that is feasible to achieve, from 2001 to 2006.

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Short-term Interest Rates (1)

By changing overnight rates, a central bank affects interest rates at different maturities, thereby influencing the real economy and prices. For instance, three-month interest rates closely follow overnight rates closely.

Policy Rules

To understand changes in short-term interest rates, it helps to look at the simple relationship that links the policy rate to core inflation and output growth. This relationship, which can be estimated with a simple regression (known as the Taylor rule), aims to capture in some crude way how policy reacts to economic conditions. (2) While it includes only a few variables, it explains the path of short-term interest rates in the U.S. and the euro area reasonably well. (3)

Note that from 1996 to 2006, the estimated response of the monetary policy rate to a change in GDP growth was larger than that of the euro areas. Such a result is consistent with the Federal Reserve's dual mandate. Note also that a change in core inflation has a much larger effect on policy rates in the euro area and in the U.S. than in Japan. This response--known as the Taylor principle--is considered essential for price stability. The idea is that when inflation increases, the central bank must raise its interest rate high enough to increase the real interest rate and reduce inflationary, pressures. If inflation rises one percentage point, for example, the central bank must raise rates by more than one percentage point.

Over the last decade or so, the Bank of Japan has faced a far different situation--deflationary, rather than inflationary pressure--to which the relationship captured by the Taylor rule did not apply. Interest rates varied minimally, hovering near their lower bound of zero.

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Inflation over the Past 25 Years

As the regressions above illustrate, inflation is a key explanatory variable of central banks' behavior. It is remarkable that the three economies under consideration here have experienced a common disinflationary process over the last 25 years. In the U.S. and Europe, inflation has decreased from about 15 percent to about 2 percent-3 percent; in Japan it has decreased from about 8 percent to 0 percent, and even went negative between 2000 and 2004. …

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