Macroeconomic stabilisation in the presence of the effective lower bound: the case of the euro area

The secular decline in the equilibrium real interest rate observed over the past decades has materially limited the room for policy-rate reductions in recessions, and has led to a marked increase in the incidence of episodes where policy rates are likely to be at, or near, the effective lower bound (ELB) on nominal interest rates. Using the ECB's New Area-Wide Model, we show that, if left unaddressed, the ELB can cause substantial costs in terms of worsened macroeconomic performance, as reflected in negative biases in inflation and economic activity, as well as heightened macroeconomic volatility. These costs can be mitigated using nonstandard instruments, notably the joint use of interest-rate forward guidance and large-scale asset purchases. This finding underpins the importance of having forward guidance and asset purchases in the central bank’s toolkit to overcome the disinflationary bias due to the ELB, as confirmed in the ECB’s new monetary policy strategy with an inflation target of 2% (ECB, 2021). Similarly, when considering alternatives to inflation targeting, we find that make-up strategies such as price-level targeting and average-inflation targeting can, if they are wellunderstood by the private sector, considerably reduce the negative biases and heightened volatility induced by the ELB. The ECB’s new strategy with its conditional commitment to an especially forceful or persistent monetary policy response to negative deviations from its inflation target when the economy is close to the ELB shares with make-up strategies the recognition that strengthening the leverage on private-sector expectations of future inflation and policy actions is key, albeit without adopting a backward-looking make-up element. SUERF Policy Briefs No 191, October 2021