Monetary Policy in Times of Crisis

Abstract

The 20th anniversary of Economic and Monetary Union (EMU) offers an opportunity to look back on the record of the European Central Bank (ECB) and learn lessons that can improve the conduct of policy in the future. This volume charts the way the ECB has defined, interpreted, and applied its monetary policy framework—its strategy—over the years from its inception, in search of evidence and lessons that can inform those reflections. Our ‘Tale of Two Decades’ is largely a tale of ‘two regimes’: one—stretching slightly beyond the ECB’s mid-point—marked by decent growth in real incomes and a distribution of shocks to inflation almost universally to the upside; and the second—starting well into the post-Lehman period—characterized by endemic instability and crisis, with the distribution of shocks eventually switching from inflationary to continuously disinflationary. We show how the most defining feature of the ECB’s monetary policy framework, its characteristic definition of price stability with a hard 2 per cent ceiling, functioned as a key shock absorber in the relatively high-inflation years prior to the crisis, but offered a softer defence in the face of the disinflationary forces that hit the euro area in its aftermath. The imperative to halt persistent disinflation in the post-crisis era therefore called for a radical, unprecedented policy response, comprising negative policy rates, enhanced forms of forward guidance, a large asset purchase programme and targeted long-term loans to banks. We study the multidimensional interactions among these four instruments and quantify their impact on inflation and the macroeconomy.

Attention to the Tail(s): Global Financial Conditions and Exchange Rate Risks

“…Figure 2 shows that the evolution of our measure over the last 20 years is broadly in line with prevailing financial market narratives (see e.g. Brunnermeier 2009;Rostagno et al 2021): for example, the left panel shows that global financial conditions tightened sharply around the collapse of Lehman Brothers in 2008 or the euro area crisis of 2010-2012. The right panel also highlights that our measure exhibits both skewness and kurtosis (fat tails), meaning both that tightenings in global financial conditions have tended to be somewhat larger than loosenings, and that larger outturns have occurred more frequently than implied by a standard Normal distribution.…”

Preferred Habitat and Monetary Policy Through the Looking-Glass

“…Our model predicts that the potency of monetary policy increases as interest rates get lower, a sharp empirical state-dependent conditionality that has received only limited attention to date. 16 One promising approach is in Rostagno et al (2021), who looked at whether reducing the policy rate by 10 basis points has a di¤erent e¤ect on the yield curve depending on whether interest rates are currently in positive or negative territory. Figure 9 reproduces their results.…”

Considerations on the Monetary Policy Framework of the European Central Bank

“…The inflation undershooting experienced by the euro area since mid-2013 provides a good example of this. While the framework design arguably made it harder to reverse the low inflation environment (Rostagno et al, 2021), other variables played a role. In particular, the combination of cyclical factors (e.g., oil and commodities) and protracted weakness in domestic demand had a disinflationary impact on the euro area since the early 2010s.…”