Monetary Policy in a Low Interest Rate Environment

Abstract

The debate on the underlying causes of the decline of interest rates to historically low levels is ongoing both in academia and among policy makers. Several explanations have been put forward, ranging from those citing real and structural factors to those underscoring the importance of cyclical and financial phenomena. However, the empirical evidence regarding their relative importance is still limited. These different but complementary views can be framed around the concept of the natural rate of interest and the monetary transmission mechanism. The low interest rate environment that still characterizes advanced economies raises important questions regarding the implications for monetary policy in the medium-and long-run. Our work provides a systematic outline of the potential changes to monetary policy strategies that could ensue.

Break-even inflation rates: the Italian case

“…Our results are in line with the empirical literature that estimates a down-trending, even negative, inflation risk premium in recent decades (Chernov and Mueller, 2012;D'Amico et al, 2018;Grishchenko and Huang, 2013;Chen et al, 2016). This pattern is consistent with a demand-side shock that pushes inflation and economic activity in the same direction (Ferrero and Neri, 2017). Under this scenario, a low (or negative) premium could be accepted by investors because nominal assets offer higher real returns.…”

“…It was deeply negative in the 1980s, consistently with the supply-side shocks that raised inflation and weakened economic growth, suggesting a positive IRP at that time. The correlation then trended up over time and switched sign with the financial crisis, meaning that the IRP turned negative around this period, consistent with interpreting the financial crisis as a large negative demand shock as noted by Ferrero and Neri (2017). Macroeconomic theory suggests that when the zero lower bound (ZLB) does not bind, the central bank can offset demand fluctuations by acting on the interest rate level, which means that demand shocks may have little effect on inflation or economic activity.…”

On secular stagnation and low interest rates: Demography matters

“…We briefly review some of these theories in this section. We refer the reader to Teulings and Baldwin () and Ferrero and Neri () for a more extensive discussion…”

“…We briefly review some of these theories in this section. We refer the reader to Teulings and Baldwin (2014) and Ferrero and Neri (2017) for a more extensive discussion. 3 Within the financial cycle view, Borio (2014) and Lo and Rogoff (2015) argue that during the 'Great Moderation', financial deregulation, excessively loose monetary policies, and overly optimistic expectations about future asset returns led to a large increase in the supply of funds, to compressed risk premia, and to lower interest rates.…”

Natural rates across the Atlantic

“…As the policy implications from these two views can be different, it is essential for the academia and policymakers to identify the factors behind the world-wide decline in real rates (17 th Geneva Report on the World Economy, Neri, 2017). This is particularly true for those central banks that have embarked in unconventional measures and that, in some cases, have brought policy rates into negative territory.…”