Philip R Lane: The monetary policy toolbox and the effective lower
bound
Welcome address by Mr Philip R Lane, Member of the Executive Board of the European Central
Bank, at the ECB Conference on Monetary Policy "bridging science and practice", Frankfurt am
Main, 11 October 2021.
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It is a pleasure to welcome you to the 2021 edition of the annual ECB Conference on Monetary
Policy. As captured in the title of this year's event, this conference series serves a vital role in
bridging the science and practice of monetary policy. In particular, it is essential for the ECB to
incorporate in our analytical framework the theoretical and empirical insights generated by the
global academic community, and the conference format (albeit in webinar mode again this year)
is very effective in providing us with a platform to discuss the latest developments. The breadth
of academic research (in terms of both topics and research techniques) that is relevant for
monetary policy is quite wide and this is reflected in the composition of the conference
programme. The agenda includes research that exploits financial market data to examine the
transmission of monetary policy, studies the impact of the pandemic on firms and banks using
entity-level datasets, analyses the interactions between monetary policy and financial stability in a
full-scale macroeconomic model, and explores the impact of monetary and fiscal policies on the
formation of household expectations. In addition, the conference features two keynote speeches
that address some of the most important issues facing central banks: monetary-fiscal
interactions and the macroeconomics of climate change.
Under normal conditions, the informal discussions at these annual conferences provide a useful
opportunity to increase external awareness of the monetary policy research conducted at the
ECB and across the Eurosystem. Since such informal interactions cannot be reproduced in
webinar format, I will take this opportunity to highlight the extraordinary research efforts of the
ECB and Eurosystem staff in supporting our recent monetary policy strategy review. In particular,
eighteen ECB occasional papers were released on 21 September. These papers provide not
only a superb series of surveys of the state of research on a given topic but also report many
substantive new research findings: I believe that these occasional papers lay important
foundations for many research programmes in academia and in central banks for years to come.
The research reported in these papers shaped our new monetary policy strategy. In particular, a
central theme of the review was to work out the implications of the trend decline in the equilibrium
real interest rate and the associated implications of the effective lower bound for the conduct of
monetary policy. One basic conclusion of the review is that it is essential to build a sufficient
medium-term inflation buffer (as captured by the symmetric two per cent inflation target) to
create the monetary policy space required to be effective in tackling negative shocks.
A second basic conclusion is that, if the economy is close to the effective lower bound, it is vitally
important to adopt especially forceful or persistent monetary policy action to avoid negative
deviations from the inflation target becoming entrenched. In turn, this may also imply a transitory
period in which inflation is moderately above target. In particular, the review identified forward
guidance, asset purchases and longer-term refinancing operations as instruments in the
monetary policy toolbox that can help to address the constraint of the effective lower bound on
policy rates.
At its 21 July monetary policy meeting, the Governing Council revised its forward guidance on
policy rates in line with this new strategic orientation. In particular, the new forward guidance
specified three conditions that need to be met before we would start raising our policy rates. The
first condition is that the Governing Council "sees inflation reaching two per cent well ahead of the
end of its projection horizon." The second condition is that the two per cent target is reached
"durably for the rest of the projection horizon." The third condition is that the Governing Council
"judges that realised progress in underlying inflation is sufficiently advanced to be consistent with
inflation stabilising at two per cent over the medium term."
Let me highlight today two key features of this rate forward guidance. First, requiring that we see
inflation reaching two per cent not only "well ahead of the end of our projection horizon" but also
"durably for the rest of the projection horizon" ensures that interest rate policy will not react to
inflation shocks that are expected to fade away before the end of our projection horizon. Second,
the condition that "realised progress in underlying inflation is sufficiently advanced to be
consistent with inflation stabilising at two per cent over the medium term" serves an important
purpose in our analysis of the incoming data: it sharply differentiates between the volatile
components of headline inflation and the dynamics of underlying inflation, which is the persistent
component that is the best guide to medium-term inflation dynamics. The inclusion of a condition
that is based on realisations of underlying inflation takes into account the intrinsic uncertainty of
economic forecasts, especially during periods of structural change that generate "disparate
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confounding dynamics".
Since the services sector constitutes a large share of the overall price level and since wages
(adjusting for productivity) are the principal component in the price of services, the persistent
component in wage dynamics plays a central role in the determination of underlying inflation.
Accordingly, tracking wage outcomes and differentiating between transitory and persistent shifts
in the growth rate of wages will play an important role in assessing progress in the realised path
of underlying inflation. In particular, a one-off shift in the level of wages as part of the adjustment
to a transitory unexpected increase in the price level does not imply a trend shift in the path of
underlying inflation.
Moreover, in examining the implications of the current increase in energy prices, it is necessary
to take into account the full macroeconomic implications of adverse external shocks and supply
shocks in the energy sector, including the associated headwinds for the economic outlook and
the negative wealth effect associated with a deterioration in the terms of trade. Through these
mechanisms, an energy price shock can simultaneously raise headline inflation but exert
downward pressure on the path of underlying inflation.
In addition to rate forward guidance, calibrating the volume of asset purchases also plays an
important role in ensuring that the monetary stance is sufficiently accommodative to deliver the
timely attainment of our medium-term two per cent target. In particular, the compression of term
premia through the duration extraction channel plays a quantitatively-significant role in
determining longer-term yields and ensuring that financing conditions are sufficiently supportive
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to be consistent with the delivery of our medium-term inflation objective.
In conclusion, in addition to learning from the research presented and discussed at this year's
event, I look forward to seeing how this year's strategy review (and our ongoing implementation
of the strategy) shapes the research that will be presented in future editions of this annual
conference series. With that, let me offer my best wishes to all conference participants for an
exciting two days.