Grasping Reality by Brad DeLong

First, as interest rates have reached their effective lower bound in the euro area, we have become more constrained in our ability to deploy conventional monetary policy tools. This has required us to develop new instruments to achieve the same results.

Second, because the use of these new instruments can have different consequences than conventional monetary policy, in particular with respect to the distribution of wealth and the allocation of resources, it has become more important that those consequences are identified, weighed and where necessary mitigated.

In my remarks today I would like to discuss how our monetary policy has evolved within this new environment – both in terms of how we have deployed our instruments and how we are managing their consequences....

Through 2014.... As the discussion of exit from accommodative monetary policy in the US gathered pace it became increasingly important for us to distinguish the diverging paths of monetary policy on either side of the Atlantic. From June onwards we therefore entered the first contingency and brought our main refinancing rate to its effective lower bound, while also introducing measures to strengthen the propagation of short-term rates to the medium-term curve.... We moved into the second contingency and launched our credit easing measures. This took the form of targeted long-term refinancing operations (TLTROs), which provide cheap long-term funding to banks on the condition that they expand loans to the real economy.... As the credit easing programme has gathered steam... competition for good credit among banks has increased. This has squeezed margins and caused bank lending rates to fall. Lower rates have in turn created more net demand for borrowing. And banks have then begun to search for the “next tier” of borrowers, leading to a gradual easing of credit standards....

In the latter part of last year, however, the inflation outlook for the euro area began to materially deteriorate.... By January 2015, the euro area was experiencing negative headline inflation rates and a generalised decline in measures of actual and expected inflation. And while the medium-term orientation of our monetary policy strategy allows us to “look through” such price developments if they are temporary in nature, there were two reasons why we feared this would not be the case. First, while the fluctuations in inflation in the second half of the year were clearly being driven by supply factors, there were strong signs that the trend was being driven by weak aggregate demand.... Second, because of this weak underlying trend in inflation, there was a higher risk that the oil price fall could feed into second round effects.... Also relevant was the fact that this loosening of inflation expectations occurred while policy rates were already at the effective lower bound.... It was in this context that we moved into the third contingency by engaging into outright asset purchases....

These asset purchases work in two main ways. First, they have a signalling effect, which contributes to re-anchoring inflation expectations more in line with our medium-term objective.... Second, even though we purchase only a comparatively narrow range of high-quality securities, our purchases have a direct and indirect effect across the whole financial system, through a portfolio balance effect.... As a result of the comprehensive easing cycle from June 2014 to January 2015, both the inflation and growth outlook have improved considerably and consumer confidence is now on the rise.... While we have already seen a substantial effect of our measures on asset prices and economic confidence, what ultimately matters is that we see an equivalent effect on investment, consumption and inflation. To that effect, we will implement in full our purchase programme.... After almost 7 years of a debilitating sequence of crises, firms and households are very hesitant to take on economic risk. For this reason quite some time is needed before we can declare success, and our monetary policy stimulus will stay in place as long as needed for its objective to be fully achieved on a truly sustained basis....

I would like to address specifically two concerns that have arisen about the possible collateral effects of our actions. These are the consequences for allocation and distribution. In terms of allocation, a key concern at the present time is that very loose financing conditions could result in a misallocation of resources, which would ultimately undermine financial stability. In particular, it has been suggested that a prolonged low rate environment can lead to excessive financial risk-taking.... It is important to underline two points. First, one has to analyse carefully the balance of effects between monetary policy and financial stability. For example, in a debt overhang environment it is not clear that accommodative monetary policy is inimical to balance sheet repair.... Second, our monetary policy decisions have not been taken in a vacuum – they have been taken in the context of a broader policy framework that helps mitigate some financial stability concerns.... While a period of low interest rates will inevitably result in some local misallocation of resources, it does not follow that it has to threaten overall financial stability....

Another concern... is the distributional consequences of monetary policy.... First of all, it is important to make clear that there are also distributional effects from monetary policy inaction – from the central bank not meeting its mandate.... Secondly, there are always distributional consequences to monetary policy decisions.... That being said, we have to be mindful that too prolonged a period of very low real rates can have undesirable consequences in the context of ageing societies...