Did the ECB respond to the stock market before the crisis?

The recent financial crisis has shown that the economic consequences of financial instability can be devastating. The consensus on the role that asset prices should play in monetary policy appears to be shifting. The pre-crisis consensus that monetary policy should only take asset prices into account, insofar as they affect inflation, is being challenged. In particular, it has recently been suggested that the monetary pillar of European Central Bank (ECB) policy provides an institutional framework to incorporate financial indicators, such as asset prices, in interest rate policy. This paper empirically examines the influence of stock price developments on the monetary policy of the ECB before the crisis. For this purpose, augmented forward-looking Taylor rules are estimated for the ECB using monthly data between 1999 and 2005. Of special interest is the effect of adding stock prices as arguments to the standard Taylor rule of the ECB. The GMM estimations suggest that the stock price developments already had an influence on ECB interest rates before the crisis. We offer an institutional explanation based on the monetary pillar of ECB policy and argue that this pillar has already served as a de facto conduit for stock prices to affect monetary policy before the outbreak of the financial crisis. We discuss the policy implications of our findings.