Philip R Lane: Monetary policy and below-target inflation
Speech by Mr Philip R Lane, Member of the Executive Board of the European Central Bank, at
the Bank of Finland conference on Monetary Policy and Future of EMU, Helsinki, 2 July 2019.
* * *
I would like to thank the Bank of Finland for inviting me to speak at this conference in Helsinki
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today.
In my contribution, I wish to share some thoughts on the conduct of monetary policy in a
lowinflation environment. This is a global topic that generates similar challenges for most of the
central banks represented at this event. To a significant extent, this sequence of low inflation
rates reflects the prolonged adjustment dynamics that characterise the aftermath of a major
global financial crisis, together with a substantial downward shift in the realisation of shocks to
inflation that we have observed in recent years. At the same time, regardless of the underlying
origins of the current low inflation environment, some observers may be tempted to query
whether and how central banks will meet their inflation objectives, especially under conditions in
which monetary accommodation is already quite extensive.
To address these concerns in respect of the euro area, I will demonstrate the effectiveness of
the policy instruments that we have deployed to ensure that inflation climbs to meet our objective
over the medium term. As will be explained in the analysis, my assessment is that the evidence
shows that our package of monetary policy measures has been an effective response to the
environment that the ECB has faced in recent years. Furthermore, the effectiveness of the policy
toolkit means that we can add further monetary accommodation if it is required to deliver our
objective.
Finally, especially when inflation deviates from its objective for an extended period, central banks
- including the ECB - should adopt clear communication strategies that leave no doubt about
their absolute commitment to meeting the inflation objective over the medium term.
The ECB's instruments and tools
Excellent accounts of the history of ECB monetary policy are provided by Hutchinson and Smets
(2017), Hartmann and Smets (2019) and Rostagno et al. (forthcoming). As a summary device,
Chart 1 shows some key interest rates and developments in excess liquidity in recent years. The
chart underlines the primary role of the deposit facility rate - which has been in negative territory
since 2014 - in anchoring the key EONIA market interest rate in a world in which the money
market operates in conditions of excess liquidity. From mid-2014 onwards, net liquidity provision
from refinancing operations and asset purchases has markedly increased. In part, this expansion
of liquidity provision depended on banks choosing to take up funding support in refinancing
operations, especially conventional longer-term refinancing operations (LTROs) and, more
recently, targeted LTROs (TLTROs). However, the expansion during 2014-18 was dominated by
our asset purchase programme (APP).
In recent years, the ECB has deployed an innovative, multi-pronged approach in the design of its
policy stance. While it is always possible to envisage a wider range of instruments, the current
policy mix includes four elements: (i) pushing the policy rate into negative territory, (ii) forward
guidance on the future policy path, (iii) the APP, and (iv) TLTROs. Importantly, these measures
work as a package, with significant complementarities across the different instruments.
I will outline the effectiveness of these four measures. Doing so shows the capacity of our policy
framework to provide the monetary accommodation required to return inflation to the
mediumterm goal, even when the policy rate is no longer in conventional positive territory. Furthermore,
the effectiveness of these tools also provides leeway for further easing if it is required.
Negative policy rate (deposit facility rate)
The 2014 decision by the ECB to push the relevant policy rate (the deposit facility rate) into
negative territory was a crucial policy innovation. Subsequent cuts have taken the deposit facility
rate to its current level of minus 40 basis points.
An important mechanism that reinforces the impact of negative interest rates relates to the way
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expectations about the future path of monetary policy are reflected in market interest rates. At
any point in time, a wide range of future interest rate paths is conceivable and market participants
assign probabilities to different parts of this distribution. The yield and forward curves observed in
the market are the probability-weighted averages of these possible paths, aggregated across
market participants.
A perceived binding lower bound on monetary policy rates skews the predictive distribution
upward, since it truncates the distribution of conceivable future short-term rates from below: as
the overnight interest rate reaches the lower bound, interest rate paths that would have embodied
expectations of a further cut at a higher level of the actual overnight rate are, by definition,
eliminated from the set of conceivable outcomes; conversely, rates above the lower bound
receive a higher relative weight and the expected value of interest rates is mechanically pushed
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up.
While longer-term yields are likely to decline even as the central bank cuts the short-term rate
towards its lower bound, the truncated asymmetric distribution of expected future short-term
rates means that they decline by less than they would away from the lower bound. The resultant
tightening bias, in turn, can be quite costly, since it tends to arise in situations of strong and
persistent disinflationary pressures and in the wake of a previous sequence of sizeable rate cuts.
A policy of negative interest rates mitigates this tightening bias. In particular, the observation that
a central bank is prepared to take interest rates to levels below zero induces a re-evaluation of
technical feasibility constraints. A salient feature of this re-evaluation is the disappearance of the
qualifier "zero" in the economic debate on lower bound constraints. Via this re-evaluation,
negative rates loosen the perceived lower bound on the future distribution of short-term interest
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rates.
Through this mechanism, negative interest rates have a marked impact on transmission,
particularly in the euro area, as they push down the short and medium segment of the risk-free
curve, which for the most part is the segment of the curve that determines the pricing of loans to
non-financial corporations. It follows that control of this segment of the curve directly influences
the level of lending rates.
To illustrate the effectiveness of negative policy rates, ECB staff undertook a counterfactual
exercise. They constructed the forward curve that would prevail in a scenario without either the
negative interest rate policy or the forward guidance on the future path of the policy rates. As
shown in Chart 2, the forward curve derived from the overnight index swap curve would be
pinned at a higher level and would be distinctly steeper (the dashed blue line on the right) than the
forward curve that we observe today (the red curve).
While this mainly serves as an illustration, as it is based on a number of assumptions and input
parameters, it is indicative of the sort of tighter interest rate constellations that the euro area
economy would face in the absence of this important policy tool. Our negative policy rate thus
contributes substantially to providing monetary accommodation. At the same time, it is also clear
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that there may be negative side effects. Accordingly, the Governing Council will continue to
assess the case for mitigating measures, which is especially relevant if further rate cuts are
envisaged.
Forward guidance on interest rates
Our interest rate forward guidance with its state-contingent and date-based legs has become the
principal tool for adjusting the monetary policy stance, especially following the end of net asset
purchases. The state-contingent leg expresses the anchor of our policy-setting expectations:
policy rates will not be raised until we are sufficiently confident that inflation will reach levels that
we consider most consistent with the ECB's price stability objective. This, in turn, allows interest
rate expectations to adjust dynamically in a data-dependent manner, which results in automatic
easing if the convergence path is delayed.
Through the date-based leg, the Governing Council affects interest rate expectations by
expressing its views about the rate path in the near term that, given the outlook for inflation, is
most conducive to reaching the objective over the medium term. This removes unnecessary
uncertainty about the policy orientation over horizons that are not stretching too far into the future
and prevents an unwanted weakening of the monetary policy stimulus.
The evidence shows that our enhanced forward guidance has been effective. The
statecontingent element is clearly understood by investors and is influencing their expectations. Since
the second half of 2018, when we enhanced our forward guidance on interest rates (and
especially since the monetary policy meeting of the Governing Council in March 2019), the
reassessment by investors of information regarding the outlook has led them to expect a
somewhat longer horizon over which rates are more likely than not to remain unchanged.
Accordingly, the EONIA forward curve has shifted down substantially over recent months (see
Chart 3).
In light of this endogenous adaptability of the state-contingent leg through investor behaviour,
occasional gaps may emerge vis-à-vis the date-based leg, since the latter can only be
recalibrated at each Governing Council monetary policy meeting. In March and June 2019, the
Governing Council assessed that the risks to price stability warranted a recalibration of the
datebased leg, thereby conveying the Governing Council's updated assessment of the direction that
the ECB's key interest rates will have to follow. The Governing Council now expects to keep
policy rates unchanged "at least through the first half of 2020".
It should be fully understood that a change to the date-based leg is not intended to ratify market
views. Rather, it provides information on the Governing Council's assessment of the rate path
that, given the evolving state of the economy, we view as the likeliest to be realised. Finally, the
inherent flexibility in our forward guidance framework always allows for additional enhancements
to ensure that inflation remains on a sustained adjustment path.
APP
The significant stock of assets purchased through the APP and the subsequent reinvestments
once net purchases ended in December 2018 have been providing substantial monetary
accommodation to the euro area. My colleague Benoît Coeuré recently provided a thorough
assessment and Chart 4 and Chart 5 illustrate the contribution of the APP to the easing of
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financial conditions through the reduction of yields. According to those estimates, after the last
recalibration of the APP in June 2018, the ten-year bond yield would have been around 95 basis
points higher in the absence of the APP. Moreover, this impact is quite persistent.
Asset purchases work through a variety of mechanisms. Of particular importance is the duration
channel. By absorbing duration risk from the market, investors require less risk compensation,
which pushes down term premia and yields. The duration channel is complemented by the
signalling channel through which asset purchases can affect the expected path of short-term
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policy rates. Importantly, the bonds we have purchased will remain on our balance sheet for a
long time and we continue to reinvest maturing principals (Chart 4). A meaningful stock effect will
therefore continue to prevail and will exert substantial downward pressure on yields (Chart 5),
particularly at the longer end of the curve.
The reinvestment horizon is linked to the forward guidance on policy rates: we now say that we
will "continue reinvesting, in full, the principal payments from maturing securities purchased
under the asset purchase programme for an extended period of time past the date when we start
raising the key ECB interest rates [...]". This means that any recalibration of the date-based leg
of forward guidance by construction extends the period over which investors expect the ECB to
continue reinvesting in full; this prolongs the favourable liquidity conditions and reinforces the
downward effect of our rate forward guidance on long-term rates by suppressing term premia
(see Chart 5).

If warranted by our policy assessment, net purchases under the APP could be restarted in the
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future. In the event of any resumption of net purchases, associated revisions to the framework
of forward guidance would have to be considered in order to make sure that the different
instruments continue to be tightly linked and that their synergies are maximised.
TLTROs
The Governing Council recently decided to start a third series of TLTROs (TLTRO III) to help
preserve favourable bank lending conditions and support the smooth transmission of monetary
policy. The generous borrowing conditions offered to banks should not only provide a backstop to
the banking system but also lower aggregate funding costs, which contributes to the overall
accommodative monetary policy stance.
The funding cost relief is direct for those banks that switch from more expensive options to
TLTRO financing. However, there is also an indirect channel that benefits the entire banking
system: while looking ahead banks will have to step up their issuance in order to satisfy
regulatory requirements, the TLTRO programme will help avoid cliff effects by allowing banks
drawing TLTRO funds to cancel or postpone plans to issue bonds in the market. This reduction
in the supply of securities relative to what we would see in the absence of TLTRO III creates a
scarcity channel that puts further downward pressure on bank bond yields, resulting in funding
cost relief across the board. The upshot of cheaper bank funding is higher credit volumes and
lower lending rates to the wider economy via the bank lending channel.9
In fact, our experience with previous TLTROs (TLTRO I and II) was that these operations had a
significant effect on funding costs, particularly in more vulnerable euro area countries. Moreover,
the lower funding costs were passed through to customers. Particularly in vulnerable countries,
banks that participated in TLTROs cut their lending rates by more than their non-participating
peers (see Chart 6).
The policy package
In assessing the impact of our policy package, we must also take into account that the
instruments were designed to be complementary and mutually reinforcing. Overall, the
transmission of our suite of measures to the financial system has been very effective. This is in
no small part due to the strong complementarities between instruments, which ensure that all
segments of the yield curve are influenced, thereby easing financial conditions more broadly (see
Chart 7).
Let me give two examples to illustrate the role played by complementarities in our policy design.
First, the negative interest rate policy has supported the portfolio rebalancing channel of the APP
by encouraging banks to lend to the broad economy instead of holding onto liquidity. At the
same time, the extra liquidity from the APP has dampened volatility at the short end of the curve.
Second, the APP and its reinvestments have supported our enhanced forward guidance via the
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signalling channel. Asset purchases provide a strong signal that policy rates will remain low for
an extended period of time. This effect is reinforced by the sequencing of our instruments, which
is embedded in the structure of our forward guidance. At the same time, our forward guidance on
rates reinforces the APP and reinvestments, since it anchors the short end of the risk-free curve
and thereby ensures that the stimulus from the APP and the reinvestments is not offset.
The improved financing conditions have made a considerable contribution to the macroeconomic
performance of the euro area. A counterfactual exercise undertaken by ECB staff shows that
growth and inflation would have been notably lower in the absence of our non-standard
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measures (see Chart 8 and Chart 9).

That said, as the Governing Council has emphasised many times, in order to reap the full
benefits from our monetary policy measures, it is important that other policy areas make a more
decisive contribution. In particular, growth-enhancing and vulnerability-reducing measures would
combine to improve confidence in the long-term potential of the euro area economy, which is a
central factor in determining assessments of steady-state real interest rates. Moreover, the
aggregate cyclical stance of fiscal policy plays an important role in determining the amplitude and
duration of economic fluctuations. As noted by President Draghi in his Sintra speech, a
cyclicallyappropriate aggregate fiscal stance may be more easily achieved through a well-designed
central fiscal capacity.
Let me now turn to the importance of effective communication in maintaining focus on the
inflation objective, especially during phases of extended deviations.
Central bank communication
The Treaty on the Functioning of the European Union establishes price stability as the primary
objective of the ECB. The ECB strategy makes the primary objective of price stability operational
through the medium-term orientation of monetary policy. This medium-term orientation provides
the necessary flexibility to combat excessive volatility in output and inflation in responding to
shocks.
The medium term refers to a time span that is long enough to be consistent with a central bank's
capacity to control inflation, taking into account the typical transmission lag. The horizon should
be short enough for the public to be able to assess the performance of the central bank in
delivering its inflation goal. At the same time, too long a span of time obstructs accountability.
However, the definition of the medium term cannot be reduced to a fixed interval: it must be
interpreted as state-dependent. A demand shock that pushes inflation away from its desired level
and output away from potential in the same direction calls for a policy horizon as short as the
typical transmission lag: the policy response to such a shock is faster and stronger than
otherwise. By contrast, if the economy is hit by persistent supply-side shocks, for example, the
medium-term interval can stretch well beyond the standard transmission lag of monetary policy.
Furthermore, a medium-term orientation implies that inflation can deviate from our aim in both
directions, so long as the path of inflation can be expected to converge back to the objective.
Maintaining a medium-term orientation is facilitated by a credible commitment to the inflation
goal, such that inflation expectations remain well anchored even during a prolonged phase of
inflation deviation. One piece of evidence on how expectations are formed is provided by a recent
special questionnaire in the ECB's Survey of Professional Forecasters (SPF), in which
participants were asked about the factors that inform their longer-term expectations, meaning
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four or five years ahead. The responses indicated that trends in inflation emerged as a
substantial driving factor, and it is fair to assume that such trends build to a very large extent on
historical and thereby backward-looking data on actual inflation. However, the ECB's inflation
objective has remained the most important factor informing the longer-term expectations of SPF
participants. Given that trends in actual inflation have clearly weakened in recent years, the role
of the inflation objective as an anchor of expectations has been brought more strongly to the fore.
One sign of this is the looser association in recent times of longer-term inflation expectations
with the average of actual inflation calculated cumulatively over the history of monetary union
(Chart 10). While this average - and the same holds for averages taken over shorter time spans
- has come down over the period of low inflation, longer-term expectations have declined to a
much lesser extent. This suggests that participants have not been overly extrapolative in forming
their expectations about inflation.
Maintaining the medium-term inflation goal as the guideline for households, firms and market
participants in forming expectations also requires a consistent communication strategy,
especially when the near-term track record of inflation outcomes has deviated from the objective.
In part, this communication strategy is anchored by our forward guidance on policy measures, so
that everyone understands that the conditional future policy path supports convergence to the
aim. It is also supported by demonstrating agility, with the central bank communicating that it
stands ready to adjust its policy measures at any time to avoid undue delay in returning to the
inflation goal and combat any adverse shock to inflation dynamics.
It is also crucial to the successful anchoring of inflation expectations that the central bank shows
it is a learning organisation that is committed in its search for the most effective policy tools in
delivering its mandate. This general principle is especially relevant during phases when
economic and financial conditions pose new challenges and require novel policy responses.
Whether through innovations such as the Outright Monetary Transactions programme during the
sovereign debt crisis or through the package of innovative policy measures that have been
launched in recent years, the ECB has shown itself to be creative and proactive in responding to
new challenges.
In common with other central banks, the ECB must always be open to new ideas and new
methods, drawing from internal and external research and examples of best practice from
around the world. Of course, not all new ideas withstand sustained scrutiny, but the exploration
of new methods and formulations is essential for successful performance. For instance, albeit
with an orientation to the specific conditions of the US economy, the academic contributions to
the June conference at the Federal Reserve of Chicago show the vibrancy of current
international research on meeting the challenges of low inflation. Some of these themes were
also identified in President Draghi's recent Sintra speech. There should be no doubt that the ECB
is committed to ensuring that our monetary policy is built on frontier-level and robust theoretical
and empirical analysis.
Conclusions
Together with the extended nature of macro-financial adjustment in the wake of a major financial
crisis, we have seen a substantial downward shift in the realisation of shocks to inflation in recent
years. In the context of the euro area, the ECB has been active and creative in deploying
nonstandard measures, in addition to extending the range for the policy rate into negative territory.
Our assessment is that this policy package has been effective and further easing can be
provided if required to deliver our mandate.
At the same time, an extended phase of below-target inflation poses a communication challenge
in maintaining focus on the medium-term inflation goal. It is obvious that it is easier to
demonstrate commitment to the target if the actual track record of inflation outcomes
corresponds more closely to the declared objective. Accordingly, it is essential that a central
bank shows consistency in its monetary policy decisions by proactively responding to shocks
that might delay convergence to the target or move inflation dynamics in an adverse direction. To
this end, especially in a world of non-standard measures and an essential role for forward
guidance, it is also vital that a central bank demonstrates that it is always seeking the most
effective methods to deliver on its mandate.
References
Albertazzi, Ugo; Altavilla, Carlo; Boucinha, Miguel and Di Maggio, Marco (2018), "The Incentive
Channel of Monetary Policy: Quasi-Experimental Evidence from Liquidity Operations", mimeo,
First Annual RTF Workshop, Frankfurt am Main.
Altavilla, Carlo; Canova, Fabio and Ciccarelli, Matteo (2016), "Mending the Broken Link:
Heterogeneous Bank Lending and Monetary Policy Pass-Through", Journal of Monetary
Economics, forthcoming.
Benetton, Matteo and Fantino, Dadvide (2018), "Competition and the Pass-Through of
Unconventional Monetary Policy: Evidence From TLTROs", Banca d'Italia Working Paper No
1187.
Bottero, Margherita; Minoiu, Cameli; Peydro, José-Louis;, Presbitero, Andrea and Sette, Enrico
(2019), "Negative Monetary Policy Rates and Portfolio Rebalancing: Evidence from Credit
Register Data," IMF Working Paper WP/19/44.
Brunnermeier, Markus and Koby, Yann (2018), "The reversal interest rate", NBER Working
Papers 25406, National Bureau of Economic Research.
Coeuré, Benoît (2019), "The effects of APP reinvestments on euro area bond markets", closing
remarks at the ECB's Bond Market Contact Group meeting, 12 June 2019.
Demiralp, Selva; Eisenschmidt, Jens and Vlassopoulos, Thomas (2019), "Negative interest
rates, excess liquidity and retail deposits: banks' reaction to unconventional monetary policy in
the euro area", Working Paper Series, No 2283, ECB.
Draghi, Mario (2019), "Twenty Years of the ECB's monetary policy", ECB Forum on Central
Banking, Sintra, 18 June 2019.
ECB (2019a), "Twenty years of the ECB Survey of Professional Forecasters", Economic
Bulletin, Issue 1.
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asset purchases", Economic Bulletin, Issue 2.
Eser, Fabian; Lemke, Wolfgang; Nyholm, Ken; Radde, Sören and Vladu, Andreea Liliana (2019),
"Tracing the impact of the ECB's asset purchase programme on the yield curve", Working Paper
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1409-1424.
1
I would like to thank John Hutchinson for his contribution to this speech.
2
Another important mechanism through which negative interest rates provide stimulus is by enhancing the
velocity of circulation of bank reserves.
3
For a formal documentation of the bias arising under the zero lower bound, see Ruge-Murcia (2006).
4
For a formal treatment of how a relaxation of the lower bound affects future rate distributions and the yield curve,
see Lemke. and Vladu (2017). For an example of a study that uses loan-level data to confirm that NIRP works
through a portfolio rebalancing channel and also incentives banks to rebalance their portfolios from liquid
assets to credit, see Bottero, Minoiu, Peydro, Polo, Presbitero and Sette (2019).
5
For example, see Brunnermeier and Koby (2018).
6
See Coeuré (2019).
7
For a more in-depth discussion of those channels and an empirical assessment, see ECB (2019b).
8
See Draghi (2019).
9
For some examples, see the following studies: Albertazzi, Altavilla, Boucinha, and Di Maggio (2018); Altavilla,
Canova, and Ciccarelli (2016); and Benetton and Fantino (2018).
See Demiralp, Eisenschmidt, and Vlassopoulos (2019).
11
See Altavilla, Carboni, and Motto (2015).
12
The macroeconomic impact reported in Rostagno et al. (2019) is broadly comparable with that in ECB (2019b)
over a comparable period.
13
For more details, see ECB (2019a).