piraeus bank group

SEE & Egypt Economic Review - November 2013

Monetary Policy in SEE: Taylor Rules with a twist

As the process of financial deepening has gained traction in the economies of Southeastern Europe, so the prominence of monetary policy has risen from obscurity.

After the global financial and European debt crisis, governments in the SEE region realized that the need to curtail fiscal deficits limited their ability to use public spending as a way of kick-starting and sustaining economic growth in the region. At that critical juncture, monetary policy came to the rescue as below par global and local activity led to a rapid decline in inflation levels. This inflation deceleration coupled with the willingness of SEE Central Banks to cut rates and accommodate stronger economic growth has brought their actions into the limelight. In the current issue of the “SEE Economic Review” we examine the extent to which local Central Banks follow a rules-based approach to monetary policy and if so which are the main variables that Central Banks react to.  Following the established approach, the workhorse of our research is the so-called Taylor Rule. According to this rule, monetary policy should be calibrated in such a way that real interest rates match the long-term growth potential of the economy, provided that economic activity and prices are close to their equilibrium levels. Positive deviations from equilibrium indicate an overheating economy, leading Central Banks to increase interest rates.  Negative deviations signal a faltering economy, leading to interest rate cuts. Empirical work in advanced economies has shown that Taylor Rules can describe Central Banks’ decisions with a significant degree of accuracy.

Nevertheless, the task at hand for the Central Banks in the SEE region is far more complicated because they need to keep track of a wider set of variables than simply inflation and growth.

According to our research, central banks in Romania, Serbia and Ukraine seem to follow a rules-based approach to monetary policy based on an augmented information set that takes into account the stability of the local exchange rate, risk premia and the monetary policy stance in the Euro area. After the recent wave of interest rate reductions, monetary policy in these economies have converged to our model estimates.  The direct consequence is that further reductions in interest rates will be limited and conditional on further disinflation and currency appreciation. The continuous update of our models will provide us with a useful forecast tool for monetary policy decisions going forward.

Ilias Lekkos

Group Chief Economist