European Central Bank working paper finds euro area fiscal policy typically moved opposite to monetary policy with QE dampening the response

The European Central Bank published Working Paper Series No 3172 by Guido Wolswijk analysing how euro area fiscal policy reacts to the monetary policy stance, estimating fiscal reaction functions for 1999-2019. The paper, which does not represent ECB views, finds that fiscal policy generally acted in a substitutive manner, with fiscal stances tending to move in the opposite direction to monetary policy, although this effect may have weakened during the ECB’s quantitative easing period. Using annual panel data for ten euro area countries and a discretionary fiscal gauge based on the structural budget balance, the preferred specification that incorporates a shadow interest rate suggests that a 1 percentage point tighter monetary stance is associated with about a 0.5 percentage point of GDP fiscal loosening. Interaction terms indicate the response was broadly muted during 2015-2019, while alternative shadow-rate measures confirm the short-term substitutive effect but do not consistently support a QE-related shift. The paper also reports that budget balances respond positively to higher government debt, consistent with fiscal sustainability, and provides evidence of countercyclical behaviour mainly in recessions, with limited response when output is above potential. Local projection results suggest the substitutive fiscal response strengthens over the first few years after a monetary policy shock before fading towards broadly neutral over the medium term.