Monetary policy expectations and aggregate EZ shocks

Máximo Camacho, Danilo Leiva-Leon, Gabriel Pérez-Quirós

01 December 2015



Market expectations and interest rate changes

Interest rates in many advanced economies have remained at (or near to) the zero lower bound for a considerable period of time. In the US, after about six years of rates close to zero, markets are expecting increases in the interest rate soon. Such expectations are motivated by a combination of low levels of inflation and positive growth. However, that is still not the case for the Eurozone, which is experiencing a continuous disinflation path while subject to weak growth and continuing attempts to recover from the Great Recession. However, as in the US, we will see markets changing their expectations of interest rates changes before actual changes happen. Monitoring variation in expectations of rates raises the question of how markets think the ECB would respond to different scenarios of inflation and real activity (Micossi 2015).

New research

In a recent paper (Camacho et al. 2015), we shed light on this question by approaching the problem in two steps.

  • First, we construct indexes of real activity and inflation for the largest economies of the Eurozone, i.e. Germany, France, Italy, and Spain.

For this purpose, we rely on dynamic factor models, which incorporate different sources of information to gauge the overall dynamics of real activity and prices.

  • Second, we use these indexes to estimate empirical (regime-switching) models that help us characterise periods where prices and quantities move in the same direction – i.e. scenarios consistent with aggregate demand shock – and periods where prices and quantities move in opposite directions – i.e. scenarios that agree with aggregate supply shocks.1

Once periods of contractionary and expansionary aggregate demand and supply shocks in the Eurozone are identified, we incorporate into our framework the information about the ECB’s current monetary policy decisions and the expectations of markets about such decisions in the future.

Our analysis shows that, especially for Germany, periods of expansionary supply shocks and contractionary demand shocks display a negative relation with changes in the ECB’s interest rate. In France and Italy such a negative relationship is also evident, especially for contractionary demand shocks. In Spain, inferences on contractionary demand shocks and the ECB’s interest rate seem to be negatively related only during the 2008 recession.

  • This provides evidence that the ECB tends to react with expansionary monetary policies during episodes of low inflation regardless of whether they appear in high-growth (expansionary supply) or in low-growth (contractionary demand) periods.

These reactions are compatible with the mandate of the Statute of the ECB (Article 2) on maintaining price stability.

What about the market’s expectations? We incorporate in our empirical framework the nominal interest rate swaps (at different horizons) to provide information about the market’s expectations on the ECB’s future monetary policy decisions. In the analysis, we find that the ECB’s monetary policy expectations tend to react negatively to contractionary shocks. Figure 1 shows that for all the countries, contractionary demand shocks affect monetary policy expectations at short horizons. We also find that contractionary supply shocks affect medium- to long-term expectations and that the effect of expansionary shocks on monetary policy expectations is not significant.2

Figure 1. Effects of contractionary demand shocks on monetary policy expectations

In sum, we find that the market assessment of the response to a monetary policy shock depends on the nature of the shock. If markets read monetary policy correctly, they believe that the monetary policy reaction function is more aggressive in response to negative demand shocks than to any other type of shock. This reaction is immediate, of similar magnitude, and significant for all countries. In the case of negative supply shocks, this effect varies across countries and is more related to the long-run than to short-run expectations. The effect of expansionary demand and supply shock is more diffuse across countries and across time delays.ConclusionThe differences in the significance of the long- and short-term effects of the shocks can be explained as follows. When contractionary supply shocks hit the economy, high inflation may be a bulwark against an immediate ECB reaction and the market only expects an ECB reaction in the medium- to long-term. By contrast, when both real activity and inflation experience a downturn, i.e. a contractionary demand shock, the market may expect a reaction soon by the ECB in cutting rates to stimulate the economy and to keep inflation close to the target.


Aruoba, B and F Diebold (2010), “Real-time macroeconomic monitoring: Real activity, inflation, and interactions”, American Economic Review 100: 20-24.

Camacho M, D Leiva-Leon and G Perez-Quiros (2015), “Country shocks, monetary policy expectations and ECB decisions. A dynamic non-linear approach”, CEPR Discussion Papers 10828.

Leiva-Leon, D (2015), “Real vs. nominal cycles: A multistate Markov-switching bi-factor Approach,” Studies in Nonlinear Dynamics and Econometrics 18: 557-580.

Micossi, S (2015), “The changing tasks of the ECB”,, 17 July.


1 For the US, similar approaches appear in Aruoba and Diebold (2015) in a linear setup and in Leiva-Leon (2015) in a nonlinear framework.

2 All the figures for the impulse response functions by country and by type of shocks are displayed in the paper.



Topics:  EU policies Monetary policy

Tags:  demand shocks, supply shocks, market expectations, monetary policy, ECB, inflation

Associate Professor of Econometrics, Universidad de Murcia

Senior Economist at the Research Department of the Central Bank of Chile

Unit Head of Macroeconomic Research, Research Department, Bank of Spain; and Research Affiliate, CEPR