Should the ECB Adjust its Strategy in the Face of a Lower r*?
The European Central Bank (ECB) launched a review of its monetary policy strategy in January 2020. Explaining its motivation for the strategy review, the ECB stated that “declining trend growth, on the back of slowing productivity and an aging population, as well as the legacy of the financial crisis, have driven interest rates down, reducing the scope for the ECB and other central banks to ease monetary policy by conventional instruments in the face of adverse cyclical developments.” A structurally lower real interest rate matters for monetary policy as, everything else being constant, it will cause the nominal interest rate to hit its effective lower bound (ELB) more frequently, hampering the ability of monetary policy to stabilize the economy and bringing about more frequent (and potentially protracted) episodes of recessions and below-target inflation. This paper contributes to this debate by asking two questions. First, to what extent does a lower steady-state real interest rate call for a change in the optimal inflation target if the central bank keeps its policy rule unchanged? Second, to what extent can a change in the policy rule be an alternative to increasing the inflation target? To address these questions, the authors conduct a quantitative welfare-based analysis that relies on an estimated structural macroeconomic model of the euro area that features less than perfect indexation of prices to past inflation.
- The paper’s simulations show that, starting from a baseline pre-2008 euro-area economy in which the natural real interest rate is 2.8 percent, a 1 percentage point drop in the rate dramatically increases the probability of hitting the effective lower bound if the central bank’s inflation target remains unchanged. So not changing the strategy would be suboptimal.
- A 1 percentage point decrease in the natural real interest rate from its pre-2008 level calls for an increase in the inflation target of roughly a 0.8 percentage point when the policy rule is unchanged. This finding holds true even if the estimation allows for emergency fiscal packages as an additional response to large recessions or under an average inflation targeting strategy.
- A change in the policy rule can be an alternative to increasing the target if the commitment to making up for inflation lost during effective lower bound episodes is sufficiently strong and credible.
- While these results are obtained using a model estimated on euro-area data, they are overall close to the ones obtained for the US economy in a previous study by the authors.
The paper’s results show that in a low-interest-rate environment, the costs resulting from the limits to stabilization induced by the effective lower bound exceed the costs entailed by increasing the inflation target. In other words, the optimal inflation target of a central bank depends on the determinants of the natural rate of interest. This calls for regular review of a central bank’s monetary policy strategy, as these determinants may change over time. The analysis also highlights which policy options other than raising the inflation target are at the central bank’s disposal in the face of a lower steady-state real interest rate. They all involve a stronger commitment to making up for foregone inflation during effective lower bound episodes.
We address the question in this paper’s title using an estimated New Keynesian DSGE model of the euro area with trend inflation, imperfect indexation, and a lower bound on the nominal interest rate. In this setup, a decrease in the steady-state real interest rate, r* , increases the probability of hitting the lower bound constraint, which entails significant welfare costs and warrants an adjustment of the monetary policy strategy. Under an unchanged monetary policy rule, an increase in the inflation target of eight-tenths the size of the drop in the real natural rate of interest is warranted. Absent an increase in the inflation target, and assuming the effective lower bound prevents the European Central Bank from implementing more aggressive negative interest rate policies, adjusting the monetary strategy requires considering alternative instruments or policy rules, such as a commitment to make up for recent, below- target inflation realizations.