What do low inflation and low interest
rates mean for monetary policy?
Amsterdam, 4 December 2019
At the farewell seminar for ABN Amro's chief economist Han de Jong, Klaas Knot
was one of the speakers. In his speech, Klaas Knot outlined the main challenges
that constitute a point of departure for the review of the ECB's strategy that is
anticipated to start formally in the new year.
It is a pleasure to say a few words in honor of Han De Jong. Han has written a great
deal about macroeconomic policy issues. The topics range from the peculiarities of
the Dutch pension system and housing market. To worldwide economic trends and
the impact of statements of politicians like Johnson and Trump. I would like to
thank Han for his valuable and thought-provoking views over the years.
As Han has been the chief economist of ABN AMRO for 14 years, he has covered a
considerable part of the lifespan of the euro. Here I have to inform you that Han
and I share a special interest in the magic number 14. Not because my own term is
maximized by law to 14 years in total. But because of our predilection for the
legendary number 14: Johan Cruijff of Amsterdam's football club Ajax. The football
team where Han and I both attend the occasional home matches.
Apart from his impact on the game, Han and I know that Cruijff's legacy also carries
lessons for chief economists and central bank governors. Han for instance already
covered the link between football and economics in 2000, when he, provokingly for
a Dutch economist, stated that a German victory during the European
Championship would be best for the euro area economy.
As Cruijff did in his days, economists have an inclination to speak in a language that
can leave an audience confused at a higher level. Or, as Johan Cruijff once
proclaimed: "If I wanted you to understand, I would have explained it better." Well,
Han's work shows the importance of explaining better, to improve all of our
understanding of the economic challenges that policymakers face. I very much hope
that you will find my contribution reflects this philosophy.
For this afternoon, I was asked to talk about the implications for monetary policy of
persistently low inflation. When preparing this speech, I remembered some advice
Han gave on monetary policy some five years ago: "The ECB should not follow the
example of the Fed and embark on QE". I wonder how Han reflects on this quote
today, looking at the current calibration of monetary policy on both sides of the
Atlantic. Whereas by now the Fed has unwound the bulk of its QE-portfolio, the ECB
restarted net purchases under its QE-program as recently as in September.
But today, I will not dwell on the merits of the policy package that was adopted in
September and has been discussed extensively afterwards. Instead, I will focus on
longer-term challenges for monetary policy. In my view, these challenges constitute
a point of departure for the review of the ECB's strategy that is anticipated to start
formally in the new year. Earlier this week, Han remarked in the Dutch newspaper
Het Financieele Dagblad that a new captain is in charge of developing a new
strategy for his team.1 Well, this is also the case for the ECB.
I will focus on three challenges affecting central banks worldwide. I will also discuss
two challenges related to the specific context in which the ECB operates. I will argue
that these challenges warrant a discussion in the upcoming review of the monetary
policy strategy on the merits of increased flexibility with respect to our inflation aim.
Three challenges for central banks worldwide
Let me start by outlining three challenges that are not unique to the ECB, but apply
more broadly to central banks worldwide.
The first challenge, of course, is the fact that in the current environment, inflation is
persistently low, and no one knows exactly why... Different possible explanations for
this phenomenon have been put forward, of which I would like to mention four:
1. We now see a weaker relationship between real economic activity and
inflation than in the past.
2. Inflation may be subject to more negative shocks than in the past.
3. Inflation expectations are increasingly backward-looking.
4. And, finally, inflation may be subject to a declining trend in some of its
underlying components. This explanation has been confirmed by recent
DNB research.2
To be more precise, I am not talking here about a secular declining trend that will
inherently go on forever. Some of the underlying drivers of this trend, like
globalization or ageing, might fade away or reverse, as was also stipulated by Carl
Tannenbaum. The process of globalization of the past decades for example might
reverse due to an ongoing escalation in protectionism.
The various explanations for persistently low inflation are interrelated and may to
some extent co-exist. In terms of their implications, they share two important
lessons:
1. The uncertainty surrounding the drivers of inflation has increased over the
years.
2. Inflation is subject to incomplete control by central bankers.3
1https://fd.nl/economie-politiek/1326407/economen-zijn-niet-de-meest-moedige-mensen
2SeeHindrayanto,I.,Samarina,A.andI.Stanga(2019).IsthePhillipscurvestillalive?Evidencefromthe
euroarea.EconomicsLetters174,149-152.
3Seealso"Thequestforpolicyscope:Implicationsformonetarypolicystrategies",speechatThefourth
annualhigh-levelconferenceRacingforEconomicLeadership:EU-USPerspectives,NewYork,16October
2019.
The second challenge relates to the reduced room for maneuver central bankers
have. When trying to address persistently low inflation, at some point monetary
policy will hit the effective lower bound on short-term interest rates. Beyond that
point, increasing side-effects start to outweigh the marginal returns of taking the
policy rate deeper into negative territory.
This lower bound is more relevant today than it was in the past. Interest rates, for a
variety of reasons mostly outside the realm of monetary policy, have declined
substantially since the 1980s.4 This implies that central banks have less
conventional policy space when confronted with a recession. In order to provide
additional accommodation with policy rates at the effective lower bound, central
banks have developed and employed unconventional monetary policy instruments.
And with unconventional monetary policy instruments comes the third challenge.
Despite the experiences gained in recent years, our understanding of
unconventional tools like forward guidance, asset purchases and long-term credit
operations is still less developed than our understanding of conventional tools.
Hence, the impact of these instruments remains subject to considerably more
uncertainty than that of conventional instruments.
Moreover, the effect of unconventional instruments on financial conditions, and
ultimately inflation, depends very much on the specific conditions under which they
are implemented. And, therefore, can also differ over time. More specifically, the
impact of balance sheet instruments crucially depends on the existence of financial
frictions. Because these frictions are what shape the impact of such central bank
interventions on financial conditions. A central bank can for instance effectively
suppress risk premia by increasing its role as an intermediary.5
There is, however, an important catch: relevant frictions may not only reflect
temporary market disfunctioning, they could also reflect more structural underlying
problems that monetary policy measures cannot resolve. If the central bank were to
respond to the latter, it would intervene in areas where other players have a
responsibility to act. The key challenge is therefore to assess which circumstances
apply, before deciding on the most appropriate instrument or set of instruments to
activate.
4Foradiscussionoftheseresultsinabroadercontext,seeBonam,D.,Galati,G.,Hindrayanto,I.,
Hoeberichts,M.,Samarina,A.andI.Stanga(2019).InflationintheeuroareasincetheGlobalFinancial
Crisis.DNBOccasionalStudyNo.3.
5SeeforinstanceGertlerandKaradi(2015),Monetarypolicysurprises,creditcosts,andeconomic
activity,AmericanEconomicJournal,7(1),44-76.
It is important to note that, next to the higher level of uncertainty, employing
unconventional tools will also likely carry larger risks, for instance in terms of
longer-run side-effects. I have therefore argued before that policymakers should
consider exercising more caution in deploying unconventional instruments.6 In times
of severe market stress with equally severe frictions, however, the advantages of
more aggressive action might outweigh the disadvantages of higher uncertainty and
larger risks.
Specific challenges for the ECB
Against this backdrop, let me focus on two additional challenges related to the
institutional context within which the ECB operates.
The first challenge here is provided by the observation that the ECB has to operate
in an incomplete monetary union with a more convoluted process of policy
coordination. The design of our Economic and Monetary Union remains a
compromise between limited risk-sharing and a large degree of national liability and
control. This confronts the ECB with more institutional restrictions than other central
banks. It has to deal with 19 different fiscal counterparts, for instance, all of which
face different sovereign risk premia. This makes the purchase of government bonds
more fraught than in other jurisdictions. To what extent further steps toward fiscal
risk-sharing should be taken, is very much a political question. From my
perspective, I can only note that more effective fiscal stabilization would have the
potential to make the ECB's job significantly easier.
The second challenge specifically faced by the ECB relates to the euro area's
financial architecture. Within the euro area, banks play a dominant role. Pervasive
banking sector weaknesses like non-performing loans and the bank-sovereign
nexus, have plagued the euro area for a long time. Given the importance of banks
for credit provision to the real economy, the ECB employed a wide variety of
unconventional instruments to address impairments in monetary transmission. At
the same time, deposit insurance schemes and macro-prudential policies are still a
national responsibility and the banking sector remains fragmented along national
lines. Financial frictions may therefore also emerge along national lines. This creates
additional uncertainties and interdependencies for the ECB.
Before I conclude, let me say some more words about the design of EMU in light of
these ECB-specific challenges I just mentioned. In the aftermath of the crisis, EMU's
functioning has been enhanced, for instance, by the establishment of the European
6"Knowsandunknownsofmonetarypolicyinstruments:implicationsformonetarypolicystrategies",
speechattheEuropeanBankingInstitute'spolicyconference,Frankfurt,14November2019.
Stability Mechanism and the steps towards a European Banking Union. Such
enhancements help align the incentives for policy action by other players with those
of us, monetary policymakers. This is helpful for monetary policy in two ways. First,
it reduces the likelihood of adverse shocks hitting the economy to which monetary
policy would need to respond. And where monetary policy would need to respond to
risks to price stability, the risk of undesirable side-effects is reduced.
There is however no room for complacency. Future steps to complete the EMU could
provide further comfort to the ECB that monetary policy will not be the only game in
town. Fostering more risk-sharing, would for instance entail developing a Capital
Markets Union and completing the Banking Union by means of a European Deposit
Insurance Scheme. This, by the way, was already foreseen by Han de Jong as early
as in 1980, when he joined the European Commission to work on proposals for
harmonizing deposit insurance schemes in Europe!
Conclusion
So let me conclude. Today I discussed what I see as the main challenges for central
banks worldwide and the ECB in particular. These challenges underline the need for
a review of the monetary policy strategy under the new ECB-presidency. And, as I
have also tried to illustrate, some of these challenges imply that elements and
lessons from other central banks cannot always be transposed onto the ECB.
A discussion is therefore warranted on the merits of increased flexibility. The ECB
has to navigate its policy in a world characterised by:
1. Elevated uncertainties surrounding the inflation process.
2. Inherent uncertainties surrounding the employment of unconventional
instruments at the effective lower bound.
3. Pervasive uncertainties as to the degree of alignment with other
policymaker's actions and its impact on financial fragmentation.
Some of the challenges, like those created by the effective lower bound, are only
relevant when inflation is below our aim. But flexibility could, in principle, be applied
in either direction: both when inflation is below or above our aim.
One way to increase the flexibility of our monetary policy strategy would be to
introduce a symmetric band around the inflation aim. Another way would be to
lengthen the time horizon over which inflation should return toward its aim. Both
approaches would buy us time and flexibility in responding to forces we simply
cannot control. In doing so, it would help us communicate our commitment to price
stability in a more appropriate fashion, by being humble about our limited control
over short-run inflation and about the inherent uncertainties surrounding
unconventional instrument applicability.
Let me then conclude with one more quote by our shared hero Johan Cruijff:
"You'll only see it, once you get it."
Han, thanks for helping us at least to see it, over these last 14 years.