Delivering a symmetric mandate with asymmetric tools: monetary policy in a context of low interest rates - Speech by Mario Draghi, President of the ECB, at the ceremony to mark the 200th anniversary of the Oesterreichische Nationalbank, - Vienna, 2 June 2016
Exactly 200 years ago today, Emperor Francis I issued two imperial decrees assigning the Oesterreichische Nationalbank the exclusive right to issue banknotes and to stabilise the finances of the empire. This was part of a growing realisation, across Europe, of the key role that central banks could play in securing monetary stability.
In 1816, monetary stability in Austria meant bringing the currency under control in the wake of the ruinous Napoleonic wars.
In the two centuries since then, the cost of not delivering stability has been painfully displayed: in the devastating effects of excessive inflation, such as the 1400% annual increase in prices recorded here in the early 1920s; but also in the terrible consequences of deflation, as in the 1930s.
This is why most modern central banks have price stability mandates. And it is why legislators have made those mandates symmetric – central banks are expected to fight persistent inflation undershooting as vigorously as they fight persistent overshooting.
In the ECB’s case, our aim is to keep inflation below but close to 2% over the medium term. Today, this means raising inflation back towards 2%. And the series of measures we have adopted in recent years – bringing policy rates into negative territory, engaging in large-scale asset purchases, and providing banks with long-term refinancing on conditional terms – are geared exactly to achieving that.
Why 2% inflation is the right objective for monetary policy
But if our aim is to avoid both excessive inflation and deflation, why do we not set a 0% inflation objective? The answer is that the rate of inflation we aim for and our ability to stabilise prices are intertwined. Or put another way, a steady state inflation rate of 2% inflation is itself a shock absorber which allows us to deliver stability. There are several reasons for this, but let me highlight two in particular.
First, a moderately positive level of inflation facilitates the adjustment of relative prices, which helps prevent short-term shocks from morphing into longer-lasting disturbances. This stems from the fact that, even in the most flexible economies, nominal wages and prices are “sticky” and slow to adjust downwards.
In that context, when demand falls, 2% inflation allows real wages to adjust downwards even if nominal wages do not. That in turn helps keep unemployment lower than would otherwise be the case, and prevents the consequences of the downturn from lasting longer than they need to – for instance, by eroding the human capital of the jobless, leading to permanently higher structural unemployment.
What is true within economies is also true across regions – and this is particularly so in a multi-country monetary union like the euro area. A 2% inflation objective means that less competitive countries can lower costs and prices relative to the area average, which allows them to recover competitiveness without destabilising consequences.
The need for such a buffer was explicitly acknowledged by the Governing Council in 2003 when we clarified our definition of price stability.[1] It has since helped countries to adjust competitiveness when required. Initially, aiming at 2% allowed some core economies to lower relative prices in a fairly painless way, as other “catching up” economies had higher inflation rates and were pulling up the area average. Today, the positions of those groups have reversed. But the rationale remains exactly the same.
The second reason why a 2% objective helps absorb shocks is that it supports the implementation of monetary policy in adverse conditions. A small positive buffer creates more scope to support the economy through cutting nominal interest rates and reduces the likelihood of running up against the effective lower bound.
This is because, for a given equilibrium real interest rate, a higher inflation objective implies higher nominal rates over the cycle. In line with the results from a larger research literature, ECB simulations made in 2003 suggested that a 2% objective would substantially decrease the probability of nominal rates reaching zero.[2] This was also recognised by the Governing Council as a reason for aiming closer to 2%.[3]
What was true then has become even more relevant now. The studies in 2003 assumed an equilibrium real rate of around 2%, so with a 2% inflation objective the equilibrium nominal rate would be around 4%. Evidence suggests, however, that demographics-induced high savings and low productivity growth have led equilibrium real rates to fall.[4] Aiming for 2% inflation is hence even more crucial today to get nominal interest rates safely away from the lower bound.
Yet it is also important to stress that the fall in real rates is by no means pre-determined. It can be reversed at least in part by structural reforms that raise productivity and participation rates. By increasing the potential for profitable investment opportunities, and by reducing the need for precautionary savings, such measures would raise the equilibrium real rate, all things being equal.
page source http://www.ecb.europa.eu/
