Does the ECB Care about Shifts in Investors’ Risk Appetite?

A key problem facing monetary policy makers is determining whether serious financial instability is present. Periods of financial instability are linked with low investors’ risk appetite (or in other words high risk aversion). Two different measures of investors’ risk aversion are used: (a) the implied volatility from the Eurostoxx 50 index (VSTOX) and (b) an index based on principal component analysis applied to risk premia of several stock portfolios in the eurozone area (12 countries) with different fundamental and size characteristics. By using an unrestricted VAR model and impulse response analysis for the period January 1999 to August 2007, our results show that a shock in the risk aversion indicator affects negatively future real activity in the eurozone in a similar way to an exchange rate shock. The ECB reacts significantly to a risk aversion shock by reducing the interest rate in order to provide liquidity. Moreover, assuming rational expectations and using a forward-looking specification of the Taylor rule, we found that investors’ risk aversion affects the ECB behavior as the leading indicator of future economic activity but not as an independent argument for the monetary policy. It views price stability and economic and financial stability as highly complementary and mutually consistent objectives to be pursued within a unified policy framework