We analyze fiscal and monetary policy interactions when interest rate policy is hampered by the zero lower bound (ZLB) in an environment where expectations are formed with perpetual learning. The ZLB induces a deterioration of economic performance and raises the risk of persistent low inflation that can disanchor inflation expectations and lead to debt deflation. Systematic use of quantitative easing (QE) can partially substitute for interest rate easing and, if sufficiently aggressive, can maintain average inflation in line with the central bank's goal. By compressing term premia on long-term interest rates, QE creates fiscal space that facilitates expansionary fiscal policy and reduces debt-deflation risk. The ZLB can be counteracted with less aggressive QE if mildly negative policy rates are feasible, if more countercyclical fiscal policy can be activated, or if the central bank can credibly communicate a clear inflation goal. Timidity in implementing QE and excessively debt-averse fiscal policies are counterproductive.

Central banks normally accept debt of their own governments as collateral in liquidity operations without reservations. This gives rise to a valuable liquidity premium that reduces the cost of government finance. The ECB is an interesting exception in this respect. It relies on external assessments of the creditworthiness of its member states, such as credit ratings, to determine eligibility and the haircut it imposes on such debt. We show how such features in a central bank's collateral framework can give rise to cliff effects and multiple equilibria in bond yields and increase the vulnerability of governments to external shocks. This policy can potentially induce sovereign debt crises and defaults that would not otherwise occur. The success of the ECB's temporary suspension of these features of its collateral framework during the pandemic illustrates the practical relevance of this mechanism.

La comparaison et le contraste des politiques adoptées par la Fed et la BCE en réponse à la crise financière mondiale de 2008 et à la pandémie de Covid-19 mettent en évidence l'importance de la dimension budgétaire de la politique monétaire, ainsi que les pièges si une banque centrale indépendante néglige la synergie des politiques budgétaire et monétaire. Pour la BCE, deux changements cruciaux dans ses politiques de réponse à la crise ont conduit à des résultats nettement meilleurs à la suite de la pandémie. Contrairement à l'hésitation dont elle a fait preuve en 2008, la BCE a élargi son bilan de manière plus adaptée en 2020 en conduisant des achats massifs de la dette publique à long terme. De plus, la BCE a suspendu les éléments de son dispositif qui avaient entravé le fonctionnement des marchés de la dette publique, comme la dépendance par rapport aux agences de notation du crédit pour déterminer l'éligibilité de la dette publique aux opérations monétaires. En protégeant les marchés des obligations d'État contre les équilibres négatifs autoréalisateurs que la BCE avait tolérés à la suite de la crise financière mondiale, la BCE a soutenu le refinancement de la dette publique à faible coût dans l'ensemble de la zone euro, plutôt que seulement dans certains États membres. Cela a facilité la mise en place d'une politique budgétaire plus expansionniste, qui a favorisé une reprise plus vigoureuse et a protégé la zone euro d'une nouvelle fragmentation. Classification JEL : E40, E50, E52, E58, E60

Comparing and contrasting the Fed’s and ECB’s policy responses to the 2008 Global Financial Crisis (GFC) and the COVID-19 pandemic highlights the importance of the fiscal dimension of monetary policy and the pitfalls that can arise when the synergy of fiscal and monetary policy is neglected by an independent central bank. For the ECB, two critical changes in its policy response led to notably better outcomes in the aftermath of the pandemic. In contrast to the hesitation it exhibited in 2008, the ECB expanded its balance sheet more appropriately in 2020 with decisive purchases of long-term government debt. Furthermore, the ECB suspended elements of its policy framework that had impaired the functioning of government debt markets, such as the reliance on credit rating agencies for determining the eligibility of government debt for monetary operations. By protecting government bond markets from the self-fulfilling adverse equilibria that the ECB had tolerated in the aftermath of the GFC, the ECB supported a low cost of refinancing government debt in the euro area overall, instead of only in selected Member States. This facilitated more expansionary fiscal policy that supported a more robust recovery, and protected against the further fragmentation of the euro area.

A monetary policy strategy that keeps inflation expectations solidly anchored in line with a clearly communicated definition of price stability supports the achievement of both price stability and economic activity goals. Providing an enduring nominal anchor succeeds in taming inflation scares and allows the Fed to respond more effectively to economic downturns. This was a key policy message in Marvin Goodfriend’s 1993 article “Interest Rate Policy and the Inflation Scare Problem: 1979-1992”. This essay connects Goodfriend’s important and timely paper to the academic and policy debates of the period and traces its influence on subsequent monetary policy research and the evolution of the Federal Reserve’s monetary policy strategy and communication.

Half a century has passed since Robert Lucas got his paper on expectations and the neutrality of money published in the Journal of Economic Theory. That article is widely considered as pathbreaking, starting a movement that changed the professional standards of doing macroeconomics. It arguably also affected the perception, if not the conduct of monetary policy and other stabilisation policies. This roundtable discussion collects comments from a panel of experts in a combination of prominent macroeconomists who have gathered ample experience of work in central banks and other authorities, and historians of economic thought.

When interest rate policy is hampered by the Zero Lower Bound (ZLB), quantitative easing and other balance sheet policies become essential tools for responding to a crisis or deflationary shock. By unleashing the power of their balance sheets at the onset of the pandemic, without the hesitation observed in past encounters with the ZLB, the Federal Reserve, the European Central Bank and the Bank of Japan provided monetary easing that cushioned the economic blow, served as a backstop to government securities and private assets that prevented a financial market meltdown and facilitated the financing of an essential fiscal expansion. This paper examines how this policy success materialized, drawing on lessons learned from previous encounters with the ZLB, and discusses policy challenges after the pandemic.

To assess the importance of inflation risk for nominal Treasury yields, a novel quadratic term structure model with time-varying inflation risk is estimated using survey-based inflation uncertainty. The resulting yield decomposition captures very diverse macroeconomic dynamics of inflation and real risk premiums (large and positive during the 1980s but small and negative post-2008) and generates sensible high-frequency estimates of expected inflation and real short rates over a long sample. The explicit link between the model-implied factors and macro fundamentals reveals that short- but not long-run fluctuations are unspanned by yields, consistent with an interest rate policy unresponsive to transient inflation shocks.

The ongoing policy strategy review presents a unique opportunity for the ECB to examine how to best employ its immense power to fulfil its mandate. Two challenges require urgent attention. First, the “lowflation” problem – the outcome of overly tight policies that allowed inflation to drift considerably below 2% over the past several years. Second, the impairment of the monetary policy transmission mechanism in the euro area – a key factor behind the divergence of economic performance of different Member States that threatens the viability of the EMU. The ECB has the authority and tools to address these challenges, within its mandate, with suitable corrections in its monetary policy strategy.

This paper explores the reasons for the suboptimal fiscal-monetary policy mix in the euro area in the aftermath of the global financial crisis and ways in which the status quo can be improved. A comparison of fiscal and monetary policies and of economic outcomes in the euro area and the United States suggests that both fiscal and monetary policy in the euro area have been overly tight. Fiscal policy has been hampered by the institutional framework which constrains individual states and lacks instruments to secure an appropriate aggregate stance. ECB monetary policy has been hampered by the distributional effects of balance sheet policies which needed to be adopted at the zero lower bound, and by discretionary decisions taken before the crisis such as the reliance on credit rating agencies for determining collateral eligibility for monetary operations. The compromising of the 'safe asset' status of euro area sovereign debt during the crisis complicated fiscal and monetary policy. Changes in the discretionary decisions governing the implementation of monetary policy in the euro area can potentially reduce the distributional effects of policy and improve the fiscal-policy mix and longer-term prospects for the euro area.

The multiple crises observed in the European Union over the past decade have undermined trust and the foundations for cohesion in Europe. In the absence of a common government, confederations without strong common independent institutions are fragile and prone to collapse. Some of the observed weaknesses in Europe today have parallels to the Delian League, a confederation of states formed in Europe in the fifth century BCE. Though initially successful, the Delian League collapsed within a century of its formation, following its transformation from a confederation of equal member states to an empire governed by Athens. Deviations from best policy practice by European institutions and the adoption of policies that appear to favor stronger Member States over weaker Member States similarly risk undermining Europe today.

What institutional arrangements for an independent central bank with a price stability mandate promote good policy outcomes when unconventional policies become necessary? Unconventional monetary policy poses challenges. The large scale asset purchases needed to counteract the zero lower bound on nominal interest rates have uncomfortable fiscal and distributional consequences and require central banks to assume greater risks on their balance sheets. Lack of clarity on the precise definition of price stability, coupled with concerns about the legitimacy of large balance sheet expansions, hinders policy: It encourages the central bank to eschew the decisive quantitative easing needed to reflate the economy and instead to accommodate too-low inflation. The experience of the Bank of Japan fs encounter with the zero lower bound suggests important benefits from a clear definition of price stability as a symmetric 2% goal for inflation, which the Bank of Japan adopted in 2013.

What institutional arrangements for an independent central bank with a price stability mandate promote good policy outcomes when unconventional policies become necessary? Unconventional monetary policy poses challenges. The large scale asset purchases needed to counteract the zero lower bound on nominal interest rates have uncomfortable fiscal and distributional consequences and require central banks to assume greater risks on their balance sheets. Lack of clarity on the precise definition of price stability, coupled with concerns about the legitimacy of large balance sheet expansions, hinders policy: It encourages the central bank to eschew the decisive quantitative easing needed to reflate the economy and instead to accommodate too-low inflation. The experience of the Bank of Japan fs encounter with the zero lower bound suggests important benefits from a clear definition of price stability as a symmetric 2% goal for inflation, which the Bank of Japan adopted in 2013.

Since the beginning of the crisis, euro area governments have experienced greater fiscal stress than governments of advanced economies outside the euro area with weaker fiscal fundamentals. What has been the source of this fragility and how can it be corrected? The cause of the instability in euro area government bond markets can be traced to a discretionary decision taken by the ECB in 2005, in the aftermath of the failure of the Stability and Growth Pact. The decision effectively delegated the determination of collateral eligibility of euro area government debt to private credit rating agencies and eventually compromised the safe asset status of government debt for most member states. This paper examines how the ECB inadvertently planted the seeds of the euro crisis and discusses how the resulting tensions can be reversed.

Monetary policy and fiscal dynamics are inexorably linked. When a government faces the risk of getting caught in a high debt trap, debt monetization may become an appealing option. However, independent central banks may be able to allay debt concerns without compromising price stability. One option is financial repression which, despite associated distortions, can create some fiscal space while preserving price stability. Financial repression is a feature of quantitative easing, which has proven to be an effective policy tool at the zero lower bound. This paper examines the policies of the Federal Reserve, the Bank of Japan and the ECB in relation to debt dynamics for the United States, Japan, Germany and Italy since the crisis. Important differences are identified across the four states, reflecting differences in the policy choices of the three central banks. While decisive QE policies by the Federal Reserve and, more recently, by the Bank of Japan have been effective, ECB policies have had decidedly uneven consequences on Germany and Italy. The normalization of the Federal Reserve’s balance sheet is also discussed in a historical context.

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By MARTIN WOLF. Penguin Press, 2014, 465 pp. Crises are an inevitable outgrowth of the modern capitalist economy. So argues Martin Wolf, chief economics commentator for the Financial Times, in his authoritative account of the 2008 financial crisis. instability reveals itself in the form of shocks; even a seemingly small deviation from the norm can set off a major crisis. Consider the decline in U.S. housing prices, which began in 2006 and hit its nadir in 2012. in isolation, the trend appeared manageable. after a period of exceptionally high housing prices, U.S. policymakers initially welcomed the drop, which they saw as a much-needed correction to the market, a gradual unwinding of excess. They did not expect a crisis of the magnitude that eventually arrived; nearly no one did

A burgeoning part of the monetary policy design literature posits that optimal monetary policy is the solution to a constrained optimization problem where the monetary authority has the discretion to minimize a social welfare function, taking the economy and other policies as given. In their paper “Is Optimal Monetary Policy Always Optimal?” Troy Davig and Refet Gurkaynak (henceforth, DG) argue convincingly that the solution thus attained may fail to deliver the desired outcome. The key insight is that any economy is characterized by multiple inefficiencies and multiple policymakers with possibly conflicting objectives, not necessarily coinciding with the social welfare function. As a result, designing policy under the false assumption that the central bank is the “only game in town” has undesirable side effects that induce inefficiencies. For example, political considerations may introduce elements other than the social welfare function to the objectives of fiscal policy. In this environment, optimality cannot be attained unless the different policies in question are jointly examined and formulated. Designing “optimal policy” is a question of the optimal mix of various policies (e.g., monetary, fiscal, regulatory, structural) for which different policymakers are responsible. The problem of “optimal policy” is not the same as the problem of “optimal monetary policy,” and equating the two yields flawed conclusions both for what monetary policy can do and for what it should do.