Philip R. Lane: Low inflation: macroeconomic risks and the monetary policy stance

SPEECH

Low inflation: macroeconomic risks and the monetary policy stance

Keynote speech by Philip R. Lane, Member of the Executive Board of the ECB, at the financial markets workshop of the Economic Council (Finanzmarktklausur des Wirtschaftsrats der CDU)

• [1] More recently, anti-inflationary shocks have dominated and addressing excessively-low inflation poses new challenges.
• In my remarks today, I therefore plan to focus on the conduct of monetary policy when inflation is below target and explain why the ECB is maintaining an accommodative monetary policy stance.
• I will also discuss why it is necessary to adopt unconventional monetary policy measures when the conventional monetary policy instrument the central banks policy rate is constrained.

Macroeconomic risks of excessively-low inflation

• One danger is that low inflation that persists over the longer term provides only a small buffer against deflation: if inflation is low, it only takes a relatively small shock to tip the economy into deflation.
• However, even in the absence of pronounced risks of deflation, there are substantial macroeconomic costs to persistently undershooting the inflation objective.
• First, excessively-low inflation can hamper beneficial macroeconomic adjustments.
• [3] Let me give the intuition with a stylised example: the nominal policy interest rate is the sum of inflation and the real interest rate.
• If inflation is stable at 2 percent, then the nominal policy interest rate also stands at 2 percent.
• This is compounded if a prolonged period of low inflation also erodes inflation expectations, since a persistent fall in inflation expectations itself further reduces the available policy space through the associated downward pressure on the yield curve.
• Prolonged low inflation risks dragging down inflation expectations which, in turn, further impairs the capacity of central banks to quickly restore inflation to the target.
• [6] The lessons from this period and the more recent experience of prolonged deflation in Japan have encouraged the adoption of monetary policy strategies worldwide that seek to deliver sufficiently positive medium-term inflation rates, given the macroeconomic risks associated with excessively-low inflation and deflation.

The contribution of non-standard measures to monetary policy capacity

• The use of non-standard measures to augment monetary policy capacity has been widespread across central banks in recent years.
• Bringing the policy interest rate to negative levels extends the scope to influence short-term funding conditions and also longer-maturity elements in the yield curve.
• In fact, since 2014 we have seen that rate reductions in negative territory propagate in qualitatively different ways than rate reductions implemented at positive levels.
• A cut below zero demonstrates that the central bank is not mechanically constrained by a zero lower bound.
• If a central bank cuts its policy rate to zero but excludes moving into negative territory, the distribution of expectations of future interest rates becomes skewed.
• As a result, interest rates at longer maturities tend to decline by less than the adjustment to the policy rate.
• [10] Taking the APP, negative rates and rate forward guidance together, ten-year sovereign bond yields would have been almost 1.4 percentage points higher in 2018 without those measures.

The monetary policy stance and the banking system

• The evidence shows that the accommodative monetary stance has been effective in encouraging banks to provide more credit and firms to boost investment.
• [12],[13] In terms of the effectiveness of the monetary stance, a countervailing factor is that the negative policy rate can mechanically weigh on the net interest income of the banking system, since banks typically do not pass on negative rates to most retail depositors.
• It is also important to recognise the overall impact of the monetary policy stance on bank profitability.
• In relation to funding costs, the banking system has benefited from the decline in wholesale rates, lower yields in the issuance of bank bonds and TLTRO funding.
• [16] In addition, the support provided by our monetary stance boosts the level of economic activity, generating higher lending volumes and lower default rates, both of which support bank profitability.
• Nonetheless, the Governing Council closely monitors the risk that the impact of negative rates on bank profitability may impair the transmission of monetary policy to the real economy.

Concluding remarks