The official view on ECB monetary policy claims that monetary decisions are based solely on average data for the euro zone and that diverging regional developments are disregarded. However, experience from other two tier central banks and theoretical considerations suggest that this official view cannot be accepted without empirical testing. A generalised monetary policy reaction function is developed which allows for an influence of regional divergence. The empirical tests are based on reaction function estimations and a probit model of interest rate decisions for the first years of the euro area. The results offer some first weak support for an impact of regional divergence in ECB decision making. The results further clarify that ignoring a potential national perspective may lead to a serious bias in the estimation of ECB reaction functions. The paper concludes that the correct identification of a possible impact of regional divergence is important for the transparency issue. JEL-Classification: E 58

Abstract:This study analyses whether expected budget deficits have an impact on interest rate swap spreads in France, Germany and Italy. We use monthly deficit forecasts from financial market participants to take the forward-looking behaviour of financial markets into account. Results of a SUR estimation show no significant impact of expected deficits on swap spreads over the whole sample period (1994)(1995)(1996)(1997)(1998)(1999)(2000)(2001)(2002)(2003)(2004). However, we find an increase in market discipline for Germany and France since the signing of the Stability and Growth Pact, and for Germany also since the start of European monetary union.Keywords: Budget deficits, interest rate swap spreads, EMU, Stability and Growth Pact JEL-Classification: C33, E43, E62, H62 Non-technical summaryThe empirical relationship between budget deficits and long-term interest rates remains unclear despite the fact that this issue has already been investigated intensely. The present paper contributes to the discussion by analysing the relationship between governmental budget balances and 10-year interest rate swap spreads for France, Germany and Italy. Interest rate swap spreads measure the government financing costs relative to high-quality private debtors' funding costs. Apart from supply and demand effects, the spread is expected to be affected by the relative default risk of the government versus the private sector. In this respect, we focus on the market disciplinary effects on public finances, ie we investigate whether financial markets respond to expected budget deficits by imposing risk premia on government bond yields.The analysis expands the existing literature (see eg Goodhart/Lemmen 1999 and Afonso/Strauch 2004) in the following ways: Firstly, the focus is on projected future budget deficit-to-GDP ratios using Consensus Forecast data. The use of expected data rather than current data takes the forward-looking behaviour of financial markets into account. Moreover, the survey data provided by Consensus Economics reflect professional forecasters' monthly expectations and are therefore more timely than most of the previous studies. Secondly, the study concentrates on EMU countries before and after the introduction of the single currency, and thereby extends the country coverage that has focused primarily on the US as single or as benchmark country. Thirdly, we raise the question of whether market discipline has changed over time, specifically with the start of EMU and its preparations in terms of the Stability and Growth Pact (SGP).Based on an SUR model, estimations covering the entire sample range from January 1994 until July 2004 do not show a significant influence of the predicted deficit ratio for 12 months ahead on the swap spread in any of the three countries. However, we find evidence of a structural break in the relationship with the start of EMU and the signing of the SGP. Estimation results for the corresponding sub-samples indicate that market discipline has increased in France and Germany since July 1997 (...

Die Discussion Papers dienen einer möglichst schnellen Verbreitung von neueren Forschungsarbeiten des ZEW. Die Beiträge liegen in alleiniger Verantwortung der Autoren und stellen nicht notwendigerweise die Meinung des ZEW dar.Discussion Papers are intended to make results of ZEW research promptly available to other economists in order to encourage discussion and suggestions for revisions. The authors are solely responsible for the contents which do not necessarily represent the opinion of the ZEW.Download this ZEW Discussion Paper from our ftp server:ftp://ftp.zew.de/pub/zew-docs/dp/dp0256.pdf Non-technical SummaryWe analyze four economic sentiment indicators for the German economy: the ifo business expectations (ifo), the European Commission's Economic Sentiment Ind icator for Germany (ESIN), the Purchasing Managers' Index (PMI) and the ZEW Indicator of Economic Sentiment (ZEW) using the year-on-year growth rate of i ndustrial production as a reference. A look at the publication schedule of the indic ators shows that all of them are released at least one month prior to the German industrial production statistics. Cross correlations indicate that the correlation between the ifo, PMI and ZEW indicators and the year-on-year growth rates of industrial production increases when the indicators are lagged. This suggests that these three indicators are indeed leading economic activity in Germany. The ESIN indicator, on the other hand, seems to lag industrial production.Subsequent Granger causality tests reveal that the ifo business expectations, the PMI and the ZEW Indicator of Economic Sentiment lead the year-on-year growth rate of German industrial production by five months. Taking into account the publication lag of industrial production (about six weeks) this lead extends to more than six months. Analyzing lead/lag structures among the ifo, PMI and ZEW indicators we find that the ZEW indicator significantly leads the ifo business expectations by one month. Furthermore, the ifo expectations indicator has a lead of one month over the PMI.Out-of-sample forecast evaluations suggest that both ifo and ZEW provide the best forecasts for industrial production among the three indicators ifo, PMI and ZEW. While the ZEW indicator performs better than the ifo over the whole sample period (Jan. 1994 -Mar. 2002 and especially over horizons from six to twelve months, the ifo predicts better at shorter horizons (up to three months) and is superior to the ZEW indicator when a shorter sample (Jan. 1998 -Mar. 2002) is regarded. The PMI exhibits the worst forecasting performance and does not beat a naive reference model at all forecasting horizons.Taken both in-sample and out-of-sample results, we conclude that while the ifo, ZEW and PMI indicator lead the release of industrial production statistics in Germany by about six months, only ifo and ZEW perform well in out-of-sample forecasts (which might be due to the short sample period for the PMI). While the ifo indicator predicts better at short horizons of up to three months, the ZEW ...

Die Discussion Papers dienen einer möglichst schnellen Verbreitung von neueren Forschungsarbeiten des ZEW. Die Beiträge liegen in alleiniger Verantwortung der Autoren und stellen nicht notwendigerweise die Meinung des ZEW dar.Discussion Papers are intended to make results of ZEW research promptly available to other economists in order to encourage discussion and suggestions for revisions. The authors are solely responsible for the contents which do not necessarily represent the opinion of the ZEW.Download this ZEW Discussion Paper from our ftp server:ftp://ftp.zew.de/pub/zew-docs/dp/dp0220.pdf Non-technical summaryWe analyze exchange rate pass-through, i.e. the change in local currency prices resulting from variations in the exchange rate, for consumer prices in the euro area. We first estimate country-specific pass-through coefficients for five large countries of the euro area (Germany, France, Italy, Spain and the Netherlands) using time series data for the past 20 years. Following this we construct a weighted average of these coefficients using the weight of each country in the Harmonized Index of Consumer Prices (HICP).As Menon (1995) in a comprehensive survey of the relevant literature points out, former empirical studies of exchange rate pass-through focus largely on the US and often neglect the time series properties of the data. To our knowledge, Ranki (2000) is the only source so far that analyzes data for the euro area. Furthermore, many recent studies analyze the pass-through to import prices of different products on the micro level rather than focussing on the effects of aggregate price measures like consumer price indices.We contribute to the existing literature in several ways. First, our study presents one of the first estimates of the effects of changes in the euro exchange rate on the Harmonized Index of Consumer Prices (HICP) in the euro area. Second, we estimate Vector Error Correction Models to take account of the non-stationarity of most of the used variables and cointegration relationships between them. Third, while a large part of the literature in the past years has focussed on the question "why" there is incomplete pass-through to import prices we present quantified effects on aggregate consumer price indices. Thus, our study is in the spirit of Kim (1998) Since aggregated time series data for the euro area are only available from 1999 on we estimate exchange rate pass-through for five large EU-countries separately and then compute an average for the euro area using the relative weight of each country in the HICP. Our country sample includes Germany, France, Italy, Spain and the Netherlands which together represent about 86 percent of the influence on the HICP. Thus, we believe our results are a rather robust estimate of the exchange rate influence.Our study uses monthly data from 1981 until 2001 and includes as variables nominal national effective exchange rate indices, short-term interest rates, output gaps constructed from industrial production, the oil price and all three stages of ...

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