The future of monetary policy frameworks
Lecture by Vítor Constâncio, Vice-President of the European Central
Bank at the Instituto Superior de Economia e Gestão
Lisbon, 25 May 2017
Ten years after the economic and financial crisis of 2007-09, the recovery in the euro area is resilient
and increasingly broad-based even if overall risks remain tilted to the downside. Monetary policy
plays a crucial role in supporting that recovery. Through a combination of interest rate cuts and
expansions of the Eurosystem balance sheet, the ECB provided the necessary degree of monetary
stimulus to prevent an even deeper cyclical downturn and to avert the risk of outright deflation. The
continuation of such monetary stimulus remains important to ensure a sustainable adjustment of
the inflation process towards levels consistent with the ECB price stability objective.
In advanced economies, many commentators have started discussing whether central banking will
eventually return to the pre-crisis status quo, or whether the many innovative tools assembled to
respond to the crisis will be a permanent feature or even whether monetary policy regime should
undergo a more complete overhaul. My intention today is to engage in this discussion which can be
divided into two themes: what should central banks' target, and which tools should they use to
reach that objective?1
In most advanced economies, central banks operate under a strategy that is consistent with the
theoretical flexible inflation targeting approach and that aims to achieve low inflation, or price
stability, as a primary objective. After the global financial crisis, this approach has come into
criticism, in particular with regards to perceived weaknesses in fighting deep recessions and the
extent to which financial stability concerns should be integrated. A range of alternatives have been
proposed, such as nominal GDP or price level targets, increasing the inflation target or even setting
policy by a mechanical formula like a Taylor Rule.
The main question that emerged after the crisis from a monetary policy framework perspective
refers to what degree financial stability considerations should be included in central banks'
competences.
1
See also Constâncio (2016).
The second theme deals with the specific policy instruments used by central banks in order to
achieve their objectives. The pre-crisis consensus in advanced economies was to rely almost
exclusively on a short-term interest rate as the monetary policy instrument. After the economic and
financial crisis, central banks have pushed the short-term interest rate to previously unthinkable low
levels - including negative in the euro area and other countries, and have created new instruments
to complement or substitute its effects. Given the experience gained with these new instruments,
the questions are whether these should become a permanent feature of the central bank toolkit, or
whether they remain non-standard measures reserved for extreme circumstances. Should central
banks be even bolder than they have been in devising new tools?
Should monetary policy strategies change?
According to Svensson (2008), inflation targeting can be broadly characterised by three elements: 1)
an announced numerical inflation target; 2) monetary policy decisions that make the inflation
forecast converge to this numerical target, and 3) a high degree of transparency and accountability.
The ECB's monetary policy strategy is consistent with these broad features. The ECB aims to
maintain price stability over the medium-term, with an announced objective of annual inflation
below, but close to, 2%. Substantial effort has been made to explain the strategy and monetary
policy decisions, by holding press conferences after the Governing Council's monetary policy
meetings, publishing detailed accounts of these meetings and delivering speeches.
Prior to the financial crisis, the performance of inflation targeting was in practice widely considered
as a success.2 To recall that in the 70s and 80s, a period that now seems in the distant past, the key
challenge for central banks was very high inflation, not too low. Empirical evidence suggests that
countries that adopted inflation targeting, beginning with New Zealand in 1989, have experienced
lower average inflation rates than they did before its adoption. For instance, in a prominent study,
Carl Walsh identifies ten inflation-targeting OECD countries and reports that the average inflation
rate across countries declined from 9.2% prior to the adoption of inflation targeting to 3.2% after the
adoption. Importantly, the decline in the level of inflation was accompanied by a decline in the
volatility of inflation and an improved anchoring of inflation expectations.3
Flexible inflation targeting implies that the central bank attempts to reach the target gradually in the
medium-term and not in the immediate period. Svensson (1997)4 has shown that this gradualism is
equivalent to an objective function that includes both the inflation rate deviation from its target and
the output gap. This is close to inflation targeting regimes of central banks with a dual mandate but
with primordial importance given to inflation as the variable in relation to which monetary policy is
more efficient. On the other hand, Bean (2009, 2013)5 has shown that no great differences exist
between a flexible inflation targeting framework and one with a nominal GDP target. These
similarities should be taken into consideration when understanding the popularity of the flexible
inflation targeting framework since the early 90s.
This positive verdict on inflation targeting has been more recently called into question. Typically,
opponents of inflation targeting rely on one of the following two arguments. First, some criticise
inflation targeting for having failed to prevent the occurrence of the crisis. Inflation-targeting central
banks, it is argued, focused too narrowly on inflation stabilisation and payed too little attention to
financial developments, such as the rapid increase in house prices or the rise in financial institutions'
leverage ratios prior to the financial crisis.6 Second, inflation targeting is attacked for its apparent
inability to speed up the recovery in economic activity and inflation.
Incorporating financial stability considerations into monetary policy decisions
Prior to the crisis, there was a common view that central banks should focus on inflation stabilisation
and only care about financial developments should these have direct implications for inflation
dynamics. Another view was that by ensuring price stability, monetary policy would also cater for
financial stability. The crisis proved that this was not true as a period of moderate inflation coincided
with the build-up of financial imbalances and asset price bubbles. It was hard to argue that
conventional monetary policy using interest rates could and should be used to address those
imbalances or prick asset price bubbles. Indeed, it is difficult to identify bubbles and virtually
impossible to calibrate interest rates to produce the desired effects on asset prices. In many cases,
the required increase in interest rates would create unnecessary recessionary episodes. The use of
monetary policy to "lean against the wind" may be very costly, as Svensson (2016) has
demonstrated. In this sense, inflation targeting cannot be blamed for failing to prevent the financial
crisis.7
Financial stability concerns should be addressed with macroprudential tools, generally of a
regulatory nature. Some of these instruments should be given to central banks to be used as
complement to monetary policy as has been the case in several countries following the crisis. This
principle is reflected in the ECB's new microprudential and macroprudential competences, including
the power to top up national macroprudential measures.
Let me now turn to the second argument against inflation targeting: its apparent inability to
engineer a quicker recovery in economic activity and inflation. To provide you with some additional
figures, it took the euro area almost eight years before real GDP reached the 2008 Q1 level again,
which marked the previous peak. Likewise, HICP inflation has been considerably below 2% since the
second half of 2013, and only more recently started to move closer to its objective. This increase in
headline inflation was however mainly driven by rising energy and food prices and not accompanied
by the evolution of underlying inflation.8
Price and nominal GDP level targeting
Against this background, some commentators argue that inflation targets should be replaced with
some sort of level target. The two most prominent examples are price level targeting and nominal
GDP level targeting, where central bank aim to stabilise the price level and nominal GDP respectively
along some target path. Proponents of level targeting strategies argue that they allow for a more
powerful management of private sector expectations, leading to better stabilisation outcomes than
under inflation targeting.9
In the case of a price level target, if there is downward pressure on the inflation rate so that the
price level falls below its target path, then future inflation has to be temporarily higher in order to
bring the price level back on track. In theory, the private sector would internalise these dynamics
and increase its inflation expectations every time there is downward pressure on the price level. In
turn, higher expected inflation would mitigate the downward pressure on today's inflation rate. This
expectations channel of monetary policy transmission associated with level targeting strategies is
especially compelling in a low interest rate environment where the effective lower bound on
nominal interest rates limits the scope for counteracting downward pressure on inflation rates by
reducing current policy rates.10 Indeed, in the United States, some central bankers have publicly
called for a temporary adoption of a level target.11
In spite of these appealing arguments based on monetary theory, level targeting strategies rely on
several strong assumptions, and I do not think that they would work in practice. First, the private
sector has to be sufficiently forward looking. That is, expectations about future economic conditions
must have a significant impact on today's economic decisions. Second, the private sector has to fully
understand the strategy and its implications for monetary policy implementation. Finally, the
strategy has to be credible, meaning that the private sector must believe that the central bank will
indeed, from time to time, deliberately aim for deviations of future inflation from its implicit
longrun target to meet its price level target.
I have serious doubts that these conditions are satisfied in practice.12 And if not, level targeting
strategies can easily result in worse stabilisation outcomes than inflation targeting.13 In this context, I
think the Hippocratic principle of "do no harm" also provides sensible advice for central bankers.
Nominal GDP growth targeting
Another proposed alternative strategy is nominal GDP growth targeting or, as economists
sometimes call it, "speed limit" policy.14 Nominal GDP growth targeting is different from nominal
GDP level targeting - as with inflation targeting, past outcomes are not taken into account. Bygones
are bygones. Loosely speaking, the nominal GDP target is the sum of an inflation target and an
estimate of potential GDP growth. The central bank tightens policy whenever nominal GDP growth is
above this target and loosens when it is below. While theoretical analyses suggest that speed limit
9
See, for example, Svensson (1999), Vestin (2006), Gaspar, Smets and Vestin (2007) and Schmidt (2011).
10
See Eggertsson and Woodford (2003), and Nakov (2008).
11
See Evans (2010).
12
Note also that in the case of nominal GDP level targeting, an additional challenge arises due to the
unobservability of potential GDP and measurement errors in real GDP.
13
See, for instance, Kryvtsov, Shukayev and Ueberfeldt (2008). It is therefore perhaps not surprising that one
has to go far back in history to find an example of a level-targeting central bank. In the 1930s, the Swedish
Riksbank pursued a price level targeting strategy. See Berg and Jonung (1999).
14
See, for instance, Walsh (2003).
policies might perform reasonably well in normal times, they are likely to perform rather poorly
when policy rates are constrained by the effective lower bound. Following a recession, they imply a
much earlier tightening of policy rates than inflation targeting.15
Simple interest rate rules
There have been some proposals, especially in the United States, to give a much more prominent
role to simple interest rate rules, the most famous example being the Taylor rule, as a guideline for
monetary policy decisions.16 The Taylor rule has been shown to provide a reasonably good ex-post
account of movements in the policy interest rate. It suggests that, at any point in time, the
shortterm interest rate is equal to a constant, plus a weighted sum of the deviations of inflation from
target and output from potential, i.e. the output gap.
The alleged advantage of using an interest rate rule to prescribe monetary policy decisions is that it
makes monetary policy more predictable and prohibits policymakers from reneging on their policy
commitments. By contrast, monetary policy decisions that are not bound by a rule are considered
problematic, since they can be driven by short-term considerations and lose sight of their
consequences on future expectations.17 A still active research programme has shown that it is
possible to design interest rate rules that perform reasonably well across a wide range of
macroeconomic models.18
While I do not dispute the informational content that interest rate rules might provide, I strongly
oppose the idea that central banks' policy rate decisions should be based on these rules. The key
reason is that any specific rule is unlikely to be suited for all possible contingencies. The environment
in which monetary policymakers have to act is much more complex than what is assumed in
modelbased analysis of policy rules. A simple rule that responds to one or two macroeconomic variables
and ignores all other indicators of price developments is not able to account for the complexities of
the real world. It would be especially odd, given the criticism that monetary policy does not take
enough account of financial developments, to put in place a strategy that completely ignores them.
Monetary policy responses to the financial crisis, which I will describe shortly, are an example. Not
only did central banks pay increasingly more attention to many new variables, when calibrating
policy interest rate to evolving economic and financial conditions but they also had to devise new
monetary policy instruments to respond to new types of financial market disruptions. What would
have happened in the last ten years, if monetary policy had been delegated to a Taylor-rule
autopilot?
15
See Woodford (2010).
16
See Taylor (1993).
17
In the literature, this is called the time-inconsistency problem and goes back to Kydland and Prescott (1977).
Barro and Gordon (1983) were the first to study this problem in the context of monetary policy rules versus
discretion. Subsequent work has shown that the time-inconsistency problem in monetary policy can also be
addressed by an appropriate design of the central bank's objective function. For instance, Rogoff (1985) shows
that an "inflation-conservative" central bank, i.e. one that is primarily concerned with price stability, eliminates
the classic inflation bias, which arises in monetary models where the central bank has an incentive to engineer
above-target inflation. Nakata and Schmidt (2015) study the time inconsistency problem for monetary policy at
the effective lower bound and show that Rogoff's inflation-conservative central banker is also
welfareimproving in this alternative environment where the problem is one of inflation expectations being too low.
18
See, for instance, Levin, Wieland and Williams (2003) and Adalid et al. (2005).
Adjustments to interest rate rules and the Effective Lower Bound (ELB)
Even though no central bank applies mechanical interest rules, it is nevertheless possible to estimate
a posteriori behavioural rules, so that in practice, interest rate decisions can be rationalised in simple
regressions dependent on inflation and the output gap. Such rules are also often used to close
models supporting monetary policy analysis or they result as the optimal policy from optimising
exercises with macro models.
It is therefore useful to use different interest rate rules in models and analyse what their impact on
the economy would be. In particular, this is interesting when trying to respond to an important
policy question. Given the present low level of inflation how can the risk of interest rates reaching
the Effective Lower Bound (ELB) too often be avoided and can this lead to significant losses in terms
of the policy objectives?19
Until recently, the conventional wisdom was that the lower bound of interest rates was zero, the
socalled Zero Lower Bound (ZLB). However, as demonstrated in recent years, the ELB can be below
zero, determined by the cost of holding cash instead of remunerated assets, including deposits.
Cash is convenient for transactions but pays no interest and is costly to store securely. It thus loses
real value when prices rise. Conversely, bank deposits generally pay interest. Should bank deposits
start being charged at negative interest rates depositors would have incentives to withdraw their
money. As holding cash is not costless, people may tolerate slightly negative interest rates.
However, as rates become more negative, depositors would withdraw their money, depriving banks
of deposits and causing financial instability and reducing banks' capacity to extend credit to the
economy. It is therefore impossible for nominal interest rates to fall below this ELB, which is
20
negative but dependent on the cost of storing and insuring cash that nevertheless can be
significant.
Kiley and Roberts (2017) investigate the question of the frequency and costs of hitting the ELB, using
stochastic simulations with two models from the Federal Reserve Board (FRB): the FRB/US Model
and a DSGE model. Using a simple Taylor Rule with a 2% objective for inflation21 and an equilibrium
real rate of 1%, they find that, for the FRB/US model, policy interest rates would be at the ELB 38%
of the time with GDP 1.1 percentage points (p.p.) below potential and inflation at 1.2%, so quite a
poor performance. The corresponding outcomes for the DSGE model were that policy rates would
be 32.5 % of the time at the ELB, with output 2.3 p.p. below potential and inflation, barely above
zero, at 0.1%.22 This illustrates how low levels of inflation and equilibrium real rates can increase the
frequency of reaching the ELB with visible deviations from the desirable policy targets.
introduction of the risk adjustment creates, of course, the risk of inflation being above 2% during
some protracted periods.
Another attempt is to use a Taylor Rule specified in terms of interest rate changes instead of levels24,
which improves the performance of both models. In the case of the FRB/US model, results are 29.7%
of the time at the ELB, GDP 1.4 p.p. below potential and inflation at 1.5% and when the DSGE model
is used 10.4% at the ELB, GDP 0.5 p.p. below potential and 1.6% inflation.
Introducing the commitment to keep the policy rate at the ELB until the targets for the output gap
(zero) and for inflation (2%) are met, further improves the results: for the FRB/US model the
outcomes for ELB, output gap and inflation are, 22%, 0.1 p.p., 2%, respectively; and 9.6%, 0 p.p., 2%
for the DSGE model. These outcomes indicate that "Policymakers capable of committing to possibly
very accommodative policies can essentially remove the pernicious effects of the ELB" 25which is a
comforting thought for the ECB.
A final possibility to avoid the dangers of falling into the ELB too often would be to increase the
inflation target.
Raising the inflation target
Several experts have argued that while central banks may want to stick to the inflation targeting
framework, this target should be raises.26 Arguments for a higher inflation target are typically related
to the ELB on nominal interest rates, which constrains interest rate policy. The first argument in
favour of raising the inflation target states that the announcement of an increase in the inflation
target raises private sector inflation expectations, which lowers real interest rates even if nominal
rates are stuck near the lower bound. Lower real rates stimulate consumption and investment and
help to raise inflation.
The second argument says that a higher inflation target increases the buffer against the ELB on
nominal interest rates in the future. Remember that in the long run, an increase in the inflation
target translates into an increase in nominal interest rates of the same size, providing central banks
with more room to lower interest rates in response to contractionary disturbances.
The argument for raising the inflation target to create a buffer against occasional episodes of binding
effective lower bound on the nominal interest rate is usually made in the context of transitory
declines in the equilibrium real rate. A stronger version of this argument applies if faced with a
situation in which the equilibrium real rate is permanently lower.27 According to standard growth
theory, the equilibrium real interest rate has some relation to long-run productivity growth. So this
touches on the so-called "secular stagnation" hypothesis recently reinvigorated by Gordon,
Krugman, Summers and others.28 Indeed, there is evidence of declining productivity since the 70s.
The issue is whether, and to what extent, the recent Great Recession and the resulting slow
deleveraging process have exacerbated this trend, generating permanent costs from the crisis. This
is a topic of heated debate at present, not only in the policy arena, but also in academic circles.29
All in all, these arguments have merits, particularly for central banks with a dual mandate that
includes output stabilisation, but they are too narrowly focused on the benefits associated with
staying away from the ELB. As going below the ELB is not possible, fighting recessions and the
resulting high unemployment rate becomes more difficult. Increasing the inflation target real
interest rates could then be effective to eliminate negative output and unemployment gaps. These
benefits of a higher inflation target can be outweighed by the broader costs of higher inflation,
depending on the chosen level. Historically, relatively higher inflation has usually been associated
with more volatile inflation.30 Moreover, the ECB and many other inflation-targeting central banks
have shown that other monetary policy tools are available when interest rates cannot be lowered
further. Against this background, the desirability of higher inflation targets becomes very
controversial as economic theory could never specify with certainty the most desirable level within
the range of low inflation values. Since the 90s most central banks defined 2% as the appropriate
inflation objective, in some cases admitting temporary small deviations around that level. In the case
of the ECB, the inflation objective is to maintain in the medium-term a level below, but close to 2%.
Should non-standard monetary policy tools become standard?
Let me now turn to the monetary policy toolkit to be employed in order to achieve central bank
targets. More specifically, should the size and composition of the central bank balance-sheet be now
thought as a conventional tool? Should the use of negative short-term interest rates be exploited
more systematically, and possibly facilitated, in reaction to deep recessions? Should central banks
exploit innovative transmission mechanisms, for example those suggesting that interest rates should
be increased to jolt the economy away from an ultra-low inflation trap?
Size and composition of central bank balance sheets
Traditionally, central banks used only short-term interest rates to steer the economy. A simplified
account of the transmission mechanism works as follows: changes in short-term rates are quickly
transmitted to other financial market prices, including longer-term rates and lending rates; these
changes translate into changes in real rates, because prices tend to remain sticky in the short-run; in
turn, real rates affect aggregate and in turn inflation.
As central banks began in the 80s to abandon technical monetarism and adopt interest rates as the
main policy instrument to influence economic and financial conditions, their monetary base has
adjusted towards the level consistent with banks' demand for reserves, given the current short-term
interest rate. The central bank balance sheet, which is to a large extent determined by bank reserves
in the perspective of the traditional transmission channels, cannot therefore be used as a monetary
policy instrument separate from the short-term interest rate.
This traditional understanding changed dramatically with the outbreak of the global financial crisis in
2008. Since then, the ECB, like many other central banks, has started using its balance sheet as an
additional monetary policy instrument while considering other transmission channels to the
economy beyond technical monetarism or interest rate effects.
In the first phase of the crisis, marked by the collapse of Lehman Brothers, the balance sheet was
used together with the short-term interest rate as a way to offset impairments in the monetary
policy transmission mechanism. For example, lending rates in some countries did not respond to
cuts in short-term rates, as interbank markets dried up and became segregated along national lines.
The ECB responded to the emerging liquidity shortage by providing ample liquidity, at increasingly
long durations and against a wider range of collateral.
As of 2014, the nature of balance sheet policies changed. The euro area had entered a prolonged
downturn as banks in large parts of the euro area further reduced lending. The sharp fall in oil prices
that began in late summer added further disinflationary pressures. In this environment of
persistently low inflation rates, the risk of a de-anchoring of private sector inflation expectations was
encountered, potentially giving rise to self-reinforcing second-round effects and deflation. Yet with
interest rates already close to zero, our ability to use conventional monetary policy to provide
additional accommodation was constrained, and we turned to the balance sheet as an
unconventional tool.31 In the second half of 2014, the ECB started to buy asset-backed securities
(ABS) under the ABS purchase programme (ABSPP) as well as covered bonds under a third covered
bond purchase programme (CBPP3).
In January 2015, the ECB announced its expanded asset purchase programme (APP), including
government bonds, to fight the risk of the period of low inflation becoming too prolonged, thereby
significantly expanding the monetary base. A broader range, beyond traditional transmission
channels, was considered, comprising: the direct effect on securities prices purchased and respective
lowering of medium-term rates; the portfolio rebalancing by banks and non-bank investor that get
liquidity and will buy other assets spreading these effects to other asset classes; finally, the signalling
32
effect influencing expectations of future inflation and the likely path of the key policy rates. The
APP allowed us to further apply downward pressure on the term structure of interest rates by
compressing risk premia out along the yield curve and improving private sector financing conditions.
Quantitative Easing (QE) has been effective both in the U.S. and in the euro area. The concept of a
"shadow interest rate"33 has been used to calculate the effect of unconventional measures (QE,
forward guidance, negative rates, etc) in a comparable way with policy interest rates when these are
constrained by the ELB. The term structure of interest rates is used to find "What policy rate would
generate the observed yield curve if the policy rate could be taken negative?" (Krippner 2012, p. 2).
As we have seen, holding cash provides protection against negative interest rates that could attain
significant values in the absence of cash as an alternative. A shadow curve is obtained from
calculating the value of a call option to hold cash at the ZLB and subtracting it from the actual yield
curve. Several methods to calculate the shadow rates based on different models of the yield curve
produce different outcomes, which somewhat diminishes the practical usefulness of the concept.
Balance sheet measures have contributed to a major easing of euro area financing conditions and,
through this channel, a more robust and sustained economic recovery.34 Given their effectiveness,
what role should central banks' balance sheets play in the future?
An important question is to investigate, in the case of a continued low inflation regime with low
interest rates, whether a conventional monetary policy of using interest rates would be sufficient to
address the next recessionary episode. Using the FRB/US model, Reifschneider (2016)35 analyses
several scenarios and concludes that both forward-guidance and QE would be necessary.
Beyond this justification, there are good arguments to preserve the instrument in the policy toolkit.
They stem from structural changes that have occurred in financial markets. In particular the
increased role of secured money market transactions; the importance of a broad set of market rates
beyond the overnight rate; the growing relevance of non-bank institutions in market-based finance;
and finally, the scarcity of safe assets that affects the functioning of markets and the management of
collateral.
These arguments are behind proposals recently presented in Jackson Hole by Duffie and
Krishnamurthy, and by Greenwood, Hanson and Stein.36 They stress the importance of the Fed's
reverse repurchase agreement (repo) programme (RRP) through which it repos against cash
securities it has in its balance sheet. The first group of authors advocate using the programme to
involve more counterparties and to affect several interest rates, thereby contributing to a better
transmission of monetary policy. Recent internal work at the ECB also detects similar pass-through
imperfections in European markets.
The second set of authors consider the necessity of central banks keeping a big balance sheet as a
way to steer the supply of safe assets, particularly through RRP, to create very short-term safe
assets, fostering greater financial stability by avoiding the unsuccessful attempts by the private
sector to fulfil that role, as seen before the crisis. This is an important issue as the attempt to create
private safer assets was behind the expansion of a shadow banking sector that played a significant
role in the crisis. An appropriate concept of shadow banking conflates entities and activities involved
in a vast array of services related to securitisation, repos and securities financing transactions (SFTs),
as well as OTC derivatives. The latter allow for risk transformation and exchange via swaps,
comprising credit default swaps, interest rate or forex swaps. Several of these activities can be
conducted either by regulated banks or by non- regulated institutions. Two aspects make these
activities relevant: first, they contribute to the creation of a credit system based on secured
shortterm market funding; second, these new liquidity instruments are akin to money but are not
counted in the usual monetary aggregates.37
These two features - the emergence of a new market credit system and the significance of new
forms of money- is what justifies the "shadow banking" designation.38
The origins of this new credit system relate to the emergence of very sizeable cash pools that could
not find safety in banks' insured deposits and were in search of safer forms of placing that cash in
the short-term.39 Securitisation, with tranches and enhanced ratings, repos creating inside liquidity
as well as risk transformation and exchange via OTC derivatives were the three main instruments
created to place these "safer" private short-term assets.
The crisis came when crashing housing prices raised doubts about securitisations and when chains of
inside liquidity created by repos with