philip r lane : monetary policy, low interest rates and low inflation dinner remarks by mr philip r lane, member of the executive board of the european central bank, at the centre for european reform, london, 27 february 2020. * * * it is a pleasure to be invited to speak at the centre for european reform. before turning to the longer - term issues that are the primary focus of this speech, i wish to comment on the coronavirus. as emphasised by president lagarde earlier today, we are closely monitoring the information about the spread of the coronavirus, which is first and foremost a public health emergency, with the most severe impact on the families of those that have died from the virus. in terms of the macro - financial implications, the more quickly is the virus contained, the smaller will be the impact on the world economy and the faster will be the recovery. conversely, more widespread contagion and a longer interruption in normal economic activity constitute additional downside risks to near - term projections. accordingly, it is a priority for the ecb to assess on a continuous basis the implications of the evolving situation for economic and financial conditions. in my remarks this evening, i aim to outline some of the factors that are relevant in understanding the role of monetary policy in the current environment of low interest rates and low inflation. 1 first, there has been a trend decline in the underlying equilibrium real interest rate since the 1980s. the equilibrium real rate ( typically labelled r * ) is the rate required to match the desired levels of saving and investment. the combination of slower population growth, rising life expectancy and an ageing population acts through multiple channels to push up desired savings and reduce desired investment. a reduction in desired investment also reflects slower productivity growth and, possibly, shifts in the structure of the aggregate production function. in the wake of the global financial crisis, risk appetite may also have diminished, which provides a disincentive to invest, reinforces the precautionary saving motive and encourages a portfolio shift to less risky assets, such as sovereign bonds. finally, the scars of the crisis have also affected desired savings and desired investment levels : many banks, firms, governments and households have focused on repairing their balance sheets or have been constrained by legacy effects when making investment decisions. some of these forces may go into reverse over time, especially if we see a more complete recovery from the crisis and if there were improved public policies to cope with demographic trends and better productivity developments ( such as

##al decision rules of private agents are based on optimisation and in the long run the model boils down to a neoclassical growth model. in the short run, however, it is assumed that agents face adjustment costs which imply staggered adjustment of the actual to the desired levels. challenges ahead i believe the design of the ecb - mc model will increase the robustness of our model - based policy analyses and strengthen our capability to address newly emerging policy questions in a timely manner. the model development, which has been led by the directorate general research, is a joint effort of economists from a wide - range of policy areas inside the ecb, colleagues from national central banks and academic consultants. i am confident it will soon be part of the ecb toolkit. however, it is easy to forecast that further refinements will prove to be necessary in the future, for the model to continue being a valuable policy tool. i specifically see four areas where significant progress has already been made, but further improvements are likely to be necessary. the first area is related to the modelling of aggregate consumption. i share the concern of muellbauer that the standard dsge framework imposes unrealistic micro - foundations for the behaviour of households as embodied in the ‘ rational expectations permanent income ’ model of 3 / 6 bis central bankers'speeches consumption. 10 in typical representative - agent models, consumption behaviour is captured by an euler equation, an inter - temporal optimality condition that links today ’ s level of consumption to expected consumption in the next period and further into the future. in its linearised form, it does neither envisage that consumers face idiosyncratic ( household - specific ) and uninsurable income uncertainty, nor that uncertainty interacts with credit or liquidity constraints. this is in stark contrast to recent research that emphasises the importance of precautionary saving, liquidity constraints, leverage and of heterogeneity, including heterogeneity in marginal propensities to consume. 11 compared to simple representative - agent models, the ecb - mc clearly marks an improvement. the consumption function is explicitly affected by agents ’ wealth holdings. 12 agents have shorter average horizons than presumed under the text - book permanent income hypothesis and the model further allows for the presence of agents that do not optimize but rather exhibit ‘ hand - to - mouth ’ behaviour. last, but not least, risk aversion and income uncertainty also play a role for consumption behaviour.