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.