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On the one hand, zero real short-term interest rates is pretty loose monetary policy, as you say.

But, if you compare Europe to the US, monetary conditions are much tighter in Europe, even though economic growth is slower there. Of course monetary conditions are extraordinarily loose over here in the US for any number of reasons -- low long-term rates, dollar depreciation, capital inflows from the rest of the world.

So it's not clear that's the right standard.

Notice though, that the ECB refi rate is still about 1/4 point above the "Taylor Rule" level:

Taylor's rule is a formula developed by Stanford economist John Taylor. It was designed to provide "recommendations" for how a central bank like the Federal Reserve should set short-term interest rates as economic conditions change to achieve both its short-run goal for stabilizing the economy and its long-run goal for inflation.

Specifically, the rule states that the "real" short-term interest rate (that is, the interest rate adjusted for inflation) should be determined according to three factors: (1) where actual inflation is relative to the targeted level that the Fed wishes to achieve, (2) how far economic activity is above or below its "full employment" level, and (3) what the level of the short-term interest rate is that would be consistent with full employment.

The rule "recommends" a relatively high interest rate (that is, a "tight" monetary policy) when inflation is above its target or when the economy is above its full employment level, and a relatively low interest rate ("easy" monetary policy) in the opposite situations.

So perhaps there is a bit more room for the ECB to reduce short-term rates, but they are not far from where we should expect them to be.

If you want to stimulate European growth to get the economy closer to full employment, however, maybe you have to be more aggressive than normal.

You could say the same thing with respect to fiscal policy: the big continental economies are all running pretty large budget deficits, but only half as large as the current US deficit, so you could argue either that it would be imprudent to increase deficits further, or that if you are really interested in spurring growth you may need to be more aggressive with tax cuts and spending increases than you might otherwise be.

It really is a dilemma, though, any way you look at it.

by TGeraghty on Tue Jun 21st, 2005 at 04:28:14 PM EST
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