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Monetary policy should prevent deflation and avoid a bad equilibrium

It has been recently suggested by a group of seasoned central bankers that there has been no danger of a deflationary spiral in the euro area. This column argues instead that the threat of a deflationary spiral was avoided by several reinforcements of the degree of monetary policy accommodation since 2015, and that a key lesson of monetary policy of the last ten years is that timely action is essential to avoid the sort of profoundly harmful equilibrium that might arise from prolonged low inflation and zero interest rates.

It has been recently argued by a group of seasoned central bankers that there has been no danger of a deflationary spiral in the euro area (Hannoun et al. 2019). That is not my recollection, and I wouldn’t make that interpretation in light of the empirical evidence. For instance, the European Commission in the years 2013-14 was very concerned about the spectre of deflation, and expressed that also publicly.

On its part, in January 2015, the ECB launched an expanded asset purchase programme, since the degree of monetary accommodation prevailing at the time was insufficient to adequately address the heightened risks of a prolonged period of low inflation. HICP inflation had indeed been below 1% since October 2013, and the reasons for low inflation, which were long seen only as temporary, started to indicate second round effects with a deflationary impact.1  

In January 2015, the overall HICP inflation rate was negative only at -0.6%. Moreover, the markets were pricing negative inflation in the time horizon of 2-3 years at a probability of about 50%. The degree of monetary policy accommodation was examined and reinforced many times since then. Only in June 2018 was the ECB Governing Council able to conclude that progress towards a sustained adjustment in inflation had been substantial. 

The threat of a deflationary spiral was subsequently avoided. A key lesson of monetary policy of the last ten years is that timely action is essential to avoid the zero lower bound and an extended period of too low inflation. We don't want to be already in the midst of a deflationary spiral at a point of time when we finally take action. This is also one of the key lessons of the Japanese experience.

Fast-forward to early 2019. Due to the rapidly worsening outlook, stemming particularly from the expanding trade war and the prolonged pervasive uncertainty created by it, the normalisation of monetary policy that started in June 2018 had to be put on hold. The decisions to restart the easing phase in March 2019 and to resume the net asset purchases in September were taken in response to the continued shortfall of both nominal and core inflation with respect to our aim. 

This does not mean that we would close our eyes to possible negative side effects of unconventional monetary policy. No central banker is a fan of negative interest rates. However, as long as the synchronised slowdown in the world economy continues, there is no meaningful alternative to unconventional monetary policies if we do not want to choke sustained growth – and it is better to be safe than sorry before shifting the policy gear back to normalisation. At the same time, all countries and jurisdictions would do well by applying effective macroprudential policies to counter negative side effects of accommodative monetary policy.

How to avoid a harmful equilibrium of low inflation and low rates?

The shortfall in inflation and the stubborn decline of inflation expectations are key challenges for monetary policy. We should take care to avoid the sort of profoundly harmful equilibrium that might arise from prolonged low inflation and zero interest rates, as this would significantly undermine the effectiveness of monetary policy, fasten economic growth below its potential, and hinder efforts to boost employment.

To steer clear of this equilibrium, it will be necessary to draw on an array of both monetary and other economic policy tools. Fiscal measures should be actively pursued, particularly towards the financing of public investment in countries with the fiscal space to do so. Structural reforms need to be harnessed to boost productivity and the economy’s growth potential and to reduce structural unemployment. In this division of labour, monetary policy needs to bring about a rise in inflation expectations and ensure that they remain well anchored with the price stability objective. 

Recent studies, such as those on the experiences of Japan over the past decades, demonstrate that declining inflation expectations can become permanently stuck at low levels. This can lead the economy into a prolonged period of low inflation, where monetary policy has little room for manoeuvre. To prevent the anchoring of expectations at a level below target, central banks need to respond early enough and powerfully enough to bring about convergence to the price stability target, in situations where inflation expectations have become depressed for a protracted period. 

Rationale for a strategy review of monetary policy frameworks

Furthermore, there are also new uncertainties originating from long-term trends and structural changes in the functioning of the economy. Low interest rates, low inflation, and persistently low growth have put our economic theories and past empirical relationships to a real litmus test.

Facing these challenges, many central banks, including the Federal Reserve and the Bank of Canada, are currently reviewing their monetary policy strategies. The Bank of Finland has been making the case for a strategy review for the ECB. Central banks in the European System of Central Banks have also invested in active research departments to analyse the implications of the new economic environment and new policy instruments, both for the conduct of monetary policy and its modelling. 

The discussions concerning a review of the ECB's monetary policy strategy have progressed over the year, and a broad consensus has emerged regarding its implementation. A strategy review referred to by Christine Lagarde would provide us with an opportunity to conduct a thorough scientific assessment of our monetary policy framework and evaluate its effectiveness in light of the new economic landscape and new monetary policy instruments (Lagarde 2019). This is welcome as it should enable us to conduct a systematic, analytical, and evidence-based debate on the operating environment for monetary policy, on the definition of price stability, and on the instruments of monetary policy. It should be done in active interaction with the economics community and those of other social sciences, as well as in a close dialogue with civil society at large.

Key questions to be addressed in the strategy review might include the following. How is the prolonged period of negative interest rates and low inflation affecting the monetary policy framework? How will the effective lower bound on interest rates limit the scope for monetary policy in the future, and how should this be factored into the policy framework? What is the comparative effectiveness of various non-standard monetary policy measures when interest rates are near the zero lower bound?

The strategy review, while sticking to the ECB’s mandate that is enshrined in the EU Treaty, might clarify both the definition of price stability and the medium-term inflation aim as well as the monetary policy reaction function.

The relationship between different policy areas is also of material importance. How is monetary policy reconcilable with financial stability? How might fiscal policy and structural reforms that support growth, employment, and productivity share the burden borne by monetary policy?

Successful implementation of the strategy review would deepen the research-based knowledge underpinning the monetary policy strategy and thereby enhance the common understanding on policy stance within the Governing Council. The review process should thus contribute to better monetary policy decision making and support consistent communication.


Lagarde, C (2019), “Opening Statement by Christine Lagarde to the Economic and Monetary Affairs Committee of the European Parliament”, 4 September.

Hannoun, H, O Issing, K Liebscher, H Schlesinger, J Stark and N Wellink (2019), “Memorandum on the ECB Monetary Policy”, 4 October.


[1] See the ECB’s Inflation Dashboard at