NEWS Release - Monetary policy in a low-growth environment - Speech by Benoît Cœuré, Member of the Executive Board of the ECB, 4th Frankfurt Conference on Financial Market Policy organised by the Sustainable Architecture for Finance in Europe Policy Centre, Goethe University, Frankfurt, 28 October 2016
Since the onset of the crisis, the ECB has introduced a wide range of unconventional measures in order to meet its inflation objective, including negative deposit facility rates, targeted long term refinancing operations, and asset purchases.
These measures were – and remain – necessary, and have been effective. But in the public debate, there is an increasing focus on the potential negative side effects of these measures and the rationale behind their deployment. This triggers two questions: why did we launch unconventional monetary policy in the first place? And how can we mitigate the potential risk of negative spillovers from monetary policy over the medium term?
The answer to the first question is clear – these measures have been taken to react to the large negative shock caused by the global financial crisis, which has exacerbated a number of structural factors that have been driving down real interest rates even before the crisis. The unconventional measures are a reaction to the challenge of low global interest rates, not their cause.
In my remarks today I will set out the challenges for monetary policy caused by structural factors such as low interest rates and low productivity growth. Understanding the structural nature of these challenges is key to answering my second question on mitigating potential spillover risks from monetary policy in the future.
The impact of low productivity growth on monetary policy
To understand the structural challenges for monetary policy, it is useful to consider two interlinked concepts for the setting of monetary policy – potential output and equilibrium interest rates. Understanding the interplay between these two concepts is at the heart of the current policy settings of the European Central Bank. How they evolve will determine the future path for inflation and at what stage monetary policy can eventually be normalised.
Potential output represents the level of activity where capital and labour are sustainably used. Equilibrium nominal rates are the level of nominal interest rates where there is neither upward nor downward pressure on activity, and are composed of two parts: the real equilibrium rate and inflation expectations. Actual levels of activity above potential put upward pressure on inflation and levels below potential put downward pressure. In similar fashion, setting actual interest rates below equilibrium rates stimulates economic activity, whereas setting interest rates above equilibrium restrains activity.
Over recent years, economic activity in the euro area has been below potential – in other words there has been a negative output gap – which has put downward pressure on inflation. The classic textbook prescription is simple: loosen monetary policy to drive interest rates below equilibrium, stimulating output to bring it back to potential and generate inflationary pressures to achieve the inflation objective. In general terms, the ECB’s monetary policy since the crisis fits that textbook prescription.
But the finer details also matter. Simple models in textbooks assume that the growth of potential output and the rate of equilibrium interest rates are fixed and immutable. In reality, productivity growth has slowed in the euro area and other advanced economies. Combined with unfavourable demographics, the slowdown in productivity has depressed potential output growth and lowered equilibrium interest rates. The productivity slowdown has been particularly pronounced in the euro area, where both total factor productivity and capital per employed person have markedly slowed down.
These changes matter for the conduct of monetary policy, and they create a dilemma. The slowdown in growth below potential has increased the need for macroeconomic stabilisation. At the same time, the overhang of public and private debt and their interaction through the bank-sovereign nexus impairs the use of fiscal policy and places a greater burden on monetary policy to carry out that stabilisation. Yet the fall in equilibrium rates reduces the margin of operation for traditional monetary policy instruments to stimulate the economy. Let me address these three elements in turn.
The greater need for macroeconomic stabilisation
Shocks constantly hit economies, driving activity away from potential and inflation away from the central bank’s objective. Recent examples include the global financial crisis and large fluctuations in oil prices. In principle, these deviations from potential output can be managed by appropriate macroeconomic stabilisation. But cyclical deviations can have more lasting effects on potential output through a process termed hysteresis.
For example, following a prolonged period of output below potential, the public may become pessimistic about future growth and income prospects and consequently reduce consumption and investment. In the short term, lower consumption and investment worsen the negative output gap and are deflationary. The lower investment also reduces longer-term capacity and hence future potential output. In a similar fashion, there is a risk of hysteresis. This means that people made unemployed due to the cyclical downturn may remain out of employment for too long, losing valuable human capital and finally becoming structurally unemployed, a tragedy for them and their families, and a loss for society.
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