The New Normal? On Euro Area Interest Rates and Monetary Policy

Abstract

The ongoing experience of generally low (and partially even negative) interest rates con-tinues to attract public attention. Particularly, the question is raised whether the low interest rate environment is merely a temporary appearance or here to stay and constitute a “new normal”. The zero lower bound is a related concept. It is important both in theory and practice as it effectively constraints monetary policy in a low interest environment. The relevance of un-conventional monetary policy measures such as quantitative and qualitative easing and forward guidance increase. Central bank credibility and reputation are key for effective monetary policy transmission. Regarding the coincidence of low interest rates, low inflation and moderate growth, Japan can claim a (rather undesired) pioneer role. A potential liquidity trap, low productivity growth and a savings overhang were put forth as specific explanations. Japanese experi-ence does not only serve as a warning, but also provides insights for the Euro Area. De-mographics and low productivity growth can be common factors. The Bank of Japan’s repeated struggles to realize target inflation likely limits the effect of Japanese monetary policy and restates the relevance of central bank credibility. The natural rate of interest, i.e. the hypothetical equilibrium interest rate of an economy, is a key concept. Various estimations consistently identify a long-term decline of the natural rate. This finding is not specific to the Euro Area but common across industrialized coun-tries, which points to the relevance of long-term and global drivers in the background. Multiple theories plausibly explain the developments but set different focuses and derive different recommendations. Secular stagnation focuses on an increased propensity to save and a decreased propensity to invest. The global savings glut stresses the role of international capital flows to the industrialized world. A related concept, the convenience yield, refers to increased premia investors are willing to pay for safety and liquidity char-acteristics of assets. The debt supercycle concentrates on still not subsided “headwinds” from the Great Recession. Finally, there is the argument that a competitiveness issue, i.e. lack of competitiveness of periphery countries relative to core countries, keeps the Euro Area down. Further (empirical) evidence from economic models and notably capital returns suggests that an increased convenience yield is the major driver, while other factors such as de-mographics and low productivity growth should play a secondary, more subordinated role. Since the underlying forces are unlikely to revert, interest rates should be expected to remain low in the future. Acting on the underlying factors is specifically beyond the scope of monetary policy, but the depressed natural rate implies that central banks will continue to face difficulties in reaching inflation objectives. This is not an acceptable outlook, also given the experience of the Bank of Japan. While the European Central Bank already exploits the common monetary policy toolkit, there are still options left. A strategy adjustment regarding the in-flation target, e.g. a higher inflation target or a price level target, could prove effective. However, the ECB’s price stability mandate has to be considered and plays a critical role. A change of the mandate should be avoided, as this would require a joint political decision of governments and in any case fuel controversial discussions. Altogether, the adoption of a price level target appears preferable in terms of efficiency and feasibility.