When the ECB embarked on its strategy review in early 2020, almost two decades after the previous strategy review, the euro area and the world economy had undergone profound changes (Lagarde 2020). One of the most significant changes has been the substantial decline in estimates of the so-called natural real rate of interest, which indicates the level of the real interest rate broadly consistent with price stability (Holsten et al. 2017, Brand et al. 2018). Since nominal interest rates are constrained from below by the effective lower bound (ELB), a lower natural rate reduces the room for interest rate reductions in response to disinflationary shocks.1 The ELB thus poses a threat to price stability that is asymmetric. Against this background, the question of how to design a monetary policy framework in a low-interest-rate environment with heightened ELB risk has been an integral part of the ECB’s strategy review (ECB 2021a).
A symmetric inflation target
The Treaty on the Functioning of the European Union specifies that the ECB’s primary objective is to maintain price stability in the euro area. Under its new strategy, the ECB’s Governing Council considers that price stability is best maintained by aiming for 2% inflation over the medium term.2 The new strategy also emphasises that the ECB’s inflation target is symmetric, with negative and positive deviations from target being equally undesirable.
The symmetry of the inflation target serves as an important counterpoint to the asymmetric threat to price stability induced by the ELB. To understand this point, let us take a closer look at how the ELB affects monetary policy and inflation expectations. A central bank can always raise the policy rate in response to an inflationary shock, thereby containing the amount by which inflation overshoots the target. In contrast, the ELB may prevent the central bank from lowering the policy rate sufficiently in response to a large disinflationary shock so that inflation may fall well below target (providing there is no perfect substitute for the policy rate in the toolkit). If agents attach a positive probability to the possibility of a binding ELB, this asymmetry in the ability of central banks to respond to shocks makes it rational for households, firms, and financial market participants to lower their inflation expectations (Adam and Billi 2007, Nakov 2008). Subdued inflation expectations, in turn, depress current inflation and economic activity. Note that this expectations channel does not require the current policy rate to be at the ELB. The mere risk of hitting the ELB in the future may give rise to a systematic shortfall of inflation below target (Hills et al. 2019).
In such a situation, an inflation objective that is unequivocally symmetric signals the central bank’s willingness to counteract the ELB-induced disinflationary bias with appropriate measures.3
Does the ECB’s symmetric inflation target facilitate the achievement of price stability over the medium term in a low-interest-rate environment? To provide a model-based answer, we must formalise the ECB’s medium-term orientation. One potential formal representation is the model’s risky steady state. The risky steady state is the point to which the economy converges when contemporaneous shocks have receded, but people take into account the risk associated with future shocks. Nakata and Schmidt (2019a) show that a monetary policy framework with a symmetric inflation target and a primary objective of price stability can indeed ensure that the risky steady state of inflation coincides with the central bank’s target.4
Of course, one may wonder whether the threat to price stability induced by the ELB could also be contained by a strategy with an asymmetric inflation target that is more willing to tolerate inflation above target than below target. However, a key disadvantage of such an asymmetric approach is that it may give rise to an inflation bias characterised by a risky steady state of inflation above target. This could happen, for example, when economic fundamentals change and the central bank fails to adjust its asymmetric target accordingly. Such an inflation bias would be inconsistent with the ECB’s medium-term price stability objective. A symmetric inflation target is thus more robust than an asymmetric inflation target of either type.
Forceful or persistent measures in the vicinity of the ELB
The second key element of the ECB’s new strategy is the explicit use of especially forceful or persistent monetary policy measures when the economy is close to the ELB. This is intended to avoid negative deviations from the inflation target becoming entrenched. The Governing Council is not deliberately aiming for inflation overshoots, a notable difference to the average inflation targeting approach adopted by the US Federal Reserve in 2020 (Board of Governors of the Federal Reserve System 2020). Nonetheless, it recognises that these measures may incidentally result in a transitory period in which inflation is moderately above target (Lagarde 2021). For example, the persistence of the policy measures in the current low-interest-rate environment is reflected in the ECB’s current forward guidance, which clarifies that the ECB will not raise policy rates until it sees inflation stabilising at target in a sustainable manner (European Central Bank 2021b).
Persistence is a common feature of optimal monetary policy in New Keynesian models (Clarida et al. 1999). In accordance with the ECB’s new strategy, the benefits of persistent policy measures are particularly prevalent in the context of the ELB (Eggertsson and Woodford 2003, Bilbiie 2019, Nakata and Schmidt 2019b). Consider, for example, a monetary policy reaction function that features state-contingent interest-rate smoothing. In most states, it responds only modestly, if at all, to the lagged policy rate, but, when the ELB becomes binding, the response coefficient on the lagged policy rate increases temporarily. In this case, after an ELB episode, the central bank adjusts the policy rate only slowly in response to changes in economic conditions. If the policy rate increases more gradually than the speed at which the economy recovers from the previous downturn, inflation will transitorily overshoot its target. The inflation overshoot in this example is a possibility rather than a necessity, and depends on the speed of the economic recovery. Nonetheless, the mere possibility of an overshoot will have a positive effect on inflation expectations during the economic downturn, when the ELB is still binding and inflation is below target. Higher inflation expectations, ceteris paribus, increase households’ desire to consume and firms’ incentives to raise prices, thereby improving macroeconomic stabilisation outcomes (e.g. Duca-Radu et al. 2021).5
The New Keynesian paradigm also provides a strong rationale for forceful policy measures in the vicinity of the ELB. While persistence is a feature of the optimal monetary policy response after an ELB episode when the disinflationary shock that has led to a binding ELB starts to recede, forcefulness is a feature of the optimal response when the shock arises and the risk of a binding ELB increases. In this situation, the central bank lowers its policy rate aggressively to keep inflation close to its target (Adam and Billi 2007, Nakov 2008).6 If the central bank instead lowered its policy rate only sluggishly in response to the disinflationary shock, inflation would fall below target even before the ELB became binding, and the downward bias in inflation expectations induced by ELB risk would increase. In fact, in New Keynesian models, it can be desirable for monetary policy to respond directly to a model-consistent measure of ELB risk (Budianto et al. 2020). In this case, when the risk of hitting the ELB is high, the central bank lowers the policy rate relatively more aggressively, such that inflation may be temporarily somewhat above target.
An aggressive reduction in the policy rate when the economy is buffeted by a disinflationary shock and approaches the ELB is one example of an especially forceful policy response. Another, potentially complementary, example is the use of additional policy instruments. For instance, the New Keynesian literature, in general, provides support for the use of central bank asset purchases when the ELB is binding. This is intended to compensate, at least partially, for the lack of further policy rate reductions (e.g. Cúrdia and Woodford 2011, Gertler and Karadi 2013).
The symmetry of the ECB’s inflation target and the use of especially forceful or persistent policy measures in the vicinity of the ELB are two key elements of the ECB’s new monetary policy strategy. I have argued in this column that both elements have strong scientific foundations, as reflected for example in the New Keynesian macro literature.
Of course, as current models are revised and extended to accommodate new research on features such as household and firm heterogeneity or the way expectations are formed, it will remain important to explore the implications of these modelling developments for the design of effective and robust policy strategies.
Author’s note: The author gratefully acknowledges comments from Michael Ehrmann, Philipp Hartmann, and Geoff Kenny. All views expressed are those of the author and should not be regarded as the views of the ECB or the Eurosystem.
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1 In New Keynesian models, the ELB is rationalised by the possibility to hold money in the form of physical currency, such that agents can avoid interest rates below a certain threshold (e.g. Eggertsson and Woodford 2003).
2 ECB (2021) provides a comprehensive discussion of the factors that have influenced the ECB’s choice of a 2% inflation objective. A strictly positive inflation target provides an additional buffer to the ELB (Coibion et al. 2012, Andrade et al. 2019, Coenen et al. 2021).
3 In contrast, a strategy that is more focused on positive deviations of inflation from target than on negative deviations, or that is perceived to favour this type of asymmetry, will amplify the downward bias in private sector expectations induced by the ELB. While the ECB has never explicitly pursued an asymmetric inflation target (Duisenberg 1999, Draghi 2016), the previous inflation target of below but close to 2% entailed the risk that relevant agents in the economy could perceive this target as asymmetric (e.g. Hartmann and Smets 2018, Rostagno et al. 2019, Angeloni 2020).
4 The high weight placed on price stability – as in Rogoff (1985) – also matters because achieving price stability in the risky steady state may require the central bank’s willingness to tolerate economic activity above potential in order to counteract the downward bias in inflation expectations.
5 Make-up strategies like average inflation targeting and price level targeting also entail a persistent interest rate response after an ELB episode. However, in the case of a make-up strategy, the central bank, after an ELB episode with below-target inflation, deliberately aims for a transitory inflation overshoot with a view to compensate for the previous inflation shortfall (Mertens and Williams 2019, Budianto et al. 2020, Eggertsson et al. 2020).
6 Optimal monetary policy, in general, also responds forcefully to inflationary demand shocks. Note however that an inflationary shock reduces ELB risk and will therefore in general require a smaller change in the policy rate than a disinflationary shock of the same size. If the occurrence of an inflationary demand shock coincides with the end of an ELB episode, the increase in the policy rate is only temporarily tempered by the persistence of the policy rate response to the ELB episode.