European Central Bank Footprints on Inflation Forecast Uncertainty

By Makarova, Svetlana | Economic Inquiry, January 2018 | Go to article overview

European Central Bank Footprints on Inflation Forecast Uncertainty


Makarova, Svetlana, Economic Inquiry


I. INTRODUCTION

One of the principal arguments for how the European Monetary Union can be economically effective in the allocative sense was made in 2005 in the speech by Ottmar Issing, then Chief Economist of the European Central Bank (ECB), at the International Research Forum on Monetary Policy. In this speech Issing (2005) reinforced his earlier point (Issing 2001) in favor of the "one size fits all" hypothesis for the single interest rate policy of the ECB. His main argument came from a reinterpretation of the real interest rate effect on growth when there are regional inflation differentials (e.g., Caporale and Kontonikas 2009). In the original interpretation, an interest rate determined by a single central bank would result in the real interest rate being relatively low in countries with high inflation, so stimulating growth, and relatively high in countries with low inflation, resulting in divergence in growth rates and increased uncertainty about inflation. Issing's counterargument was that investment decisions are based on ex ante rather than ex post real interest rates, or expected rather than historical inflation. If expected inflation is not idiosyncratic, then its dispersion between countries will not increase and no divergence in growth will occur.

Ten years after the speech the empirical evidence has been mixed. Some signs of inflation convergence were noticed 5 years after the creation of the euro (Busetti et al. 2007; Mongelli and Vega 2006) and were confirmed later (Lopez and Papell 2012), but the empirical support of real sphere convergence in the euro area is less evident. Although there are signs that there was convergence in output and unemployment before 2007, substantial divergence has been observed after that date (Estrada, Gali, and Lopez Salido 2013; Monfort, Cuestas, and Ordonez 2013). This makes it difficult either to disprove or to confirm Issing's hypothesis by evaluating the traditional convergence hypothesis.

However, convergence in levels of inflation does not necessarily imply that inflation uncertainty converges as well. This article attempts to shed new light on the "one size fits all" hypothesis and provide empirical evidence of a different type based on an evaluation of the effects of monetary policy on inflation uncertainty. The logic here is that Issing's (2005) conjecture that investment decisions are based on an ex ante real interest rate reflecting the entire euro area implies that there is some uncertainty about future euro inflation. There may be some external factors, fiscal or political, which increase inflation uncertainty from its relatively low level. In this context, the question arises of whether the economic policy of the euro area can successfully reduce the uncertainty by a similar proportion across countries. In a way this also relates to the conjecture of Arnold and Lemmen (2008) that, within the euro area, "inflation uncertainty may increase in countries that have a smaller influence on ECB policy."

The traditional approach to measure inflation uncertainty is to calculate a measure of its variability and then evaluate changes in it over time (e.g., Caporale, Onorante, and Paesani 2012; Lopez and Papell 2012). As high inflation usually corresponds to higher dispersion of inflation, ex post or ex ante, periods of high inflation were historically associated with higher uncertainty. Other approaches are needed, however, in the current economic realities when the level of inflation is low. There is a growing literature discussing different approaches in defining and measuring inflation uncertainty and, more generally, macroeconomic uncertainty (e.g.. Baker, Bloom, and Davis 2015; Giordani and Soderlind 2003; Jurado, Ludvigson, and Ng 2015; Makarova 2014 for a comprehensive discussion and overview). Inflation uncertainty is generally regarded as being detrimental to growth, either directly through the effect on long-term interest rates (Golob 1994), or indirectly as a component of macroeconomic uncertainty, where it affects long-term transactional insurance and option costs (Bloom 2014). …

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