Post-COVID Exogenous and Endogenous ECB Monetary Policy II

Endogenous vs exogenous ECB monetary policy

When the ECB's monetary policy endogenously reacts to the Fed tightening, the effect on real activity and inflation is smoothed out. In fact, a unilateral tightening in the US prompts a depreciation of the bilateral exchange rate of the Euro against the US dollar. The ECB would then potentially be tightening monetary policy in order to counter an increase in inflation in the Euro Area. Such a monetary policy reaction would partly offset the initial depreciation and cause an overreaction. As a result, the effective exchange rate would not fall as much as it would in a case where the ECB Monetary Policy is exogenous.

The Impact on Emerging Markets

The monetary policy divergence between the ECB and Fed does however extend beyond the bilateral spillovers between these two large economies. The two central banks have considerable cross-border influence on emerging market economies, or EMEs. This is demonstrated by events such as the 'taper tantrum' illustrating the importance of financial linkages and capital flows in the propagation of shocks across countries. Most EMEs go through a depreciation of about -0.8 to -2.5 percent, with the lowest values observed in Mexico and India following a Fed tightening. In the case of the ECB, monetary policy tightening is not shown to affect US, and as a result, Chinese monetary policy very much. Unlike bilateral spillovers between the Euro Area and the United States, our findings imply that if ECB and Fed monetary policy measures are not in sync, policy trade-offs may lead to unfavourable international spillovers.