Monetary policy in times of crisis and structural change Research Areas and Programme
Introduction
In the aftermath of the global financial crisis and the European sovereign debt crisis, policy rates in the euro area have remained at exceptionally low levels. Moreover, the ECB has introduced an extended toolkit of unconventional measures, which have sharply increased the size of the Eurosystem’s balance sheet. The COVID-19 pandemic required further exceptional monetary support and has also contributed to unprecedented levels of public debt, with potential consequences for the interaction of monetary and fiscal policies. Moreover, structural economic shifts related to climate change, the digitalisation of the economy, demographic change and a changing international environment will continue to affect inflation dynamics and the conduct of monetary policy in coming years. Bundesbank research focuses on analysing these developments and their consequences for central banks.
Topics of the Research Area
The exceptionally low inflation rates in the euro area and many other developed countries in recent years raise questions concerning our understanding of the drivers and dynamics of inflation, particularly over the longer term. The Bundesbank’s research therefore examines potential structural factors for long-lasting low inflation. Among these, researchers investigate the contribution of global versus domestic inflation drivers, the role of product markets for price setting by exploring micro price data, and the implications of demographic developments for productivity and therefore the inflation process.
In addition to structural factors, Bundesbank research analyses the cyclical determinants of inflation. Amongst other drivers, the recent literature highlights the relevance of economic uncertainty. Bundesbank research contributes to this literature by studying the effects of uncertainty during the COVID-19 pandemic, for example. While uncertainty was also elevated during the global financial crisis, this episode primarily highlighted the importance of frictions in the financial system for macroeconomic dynamics. The Bundesbank’s research analyses the implications of such frictions for the monetary transmission process and for the efficacy of unconventional monetary policy measures – for example quantitative easing and negative interest rates – and for households’ and firms’ investment and savings decisions.
Like other major central banks, the Eurosystem has recently engaged in a review of its monetary policy framework. The aim of this review was to ensure that the monetary policy strategy remains fit for purpose in order to maintain price stability in a world undergoing substantial structural change and also to incorporate the lessons learned during the recent crises. Although the strategic review was completed in July 2021, several of the aspects it considered will remain important for Bundesbank research in the coming years. For example, the constraints imposed by effective lower bounds (ELB) on interest rates have made the management of inflation expectations via forward guidance and other forms of communication a key tool for many central banks.
Alternative monetary policy strategies, such as average inflation targeting, also heavily rely on the management of inflation expectations. By making monetary policy history-dependent, such strategies prescribe an automatic stabiliser role for inflation expectations and thus real interest rates. While the theoretical advantages of history-dependent monetary policy strategies are relatively well understood, many questions remain unanswered concerning their implementation. Research at the Bundesbank investigates from a theoretical standpoint how belief formation by households and firms may affect the efficacy of the monetary policy transmission at and away from the ELB. Moreover, Bundesbank research assesses to what extent historydependent monetary policy rules ensure unique macroeconomic equilibrium conditions when the ELB is expected to be binding occasionally.
Whereas most topics in research area 1 have a macroeconomic perspective, several research projects also incorporate a microeconomic view so as to shed more light on the impact of microeconomic decisions on macroeconomic policy. For example, monetary policy strategies that strongly rely on the management of expectations require a deep understanding of how the expectation formation of households and firms works in practice. This includes the availability of reliable empirical measures of inflation expectations and evidence on their reaction to monetary policy communication. In this context, Bundesbank research analyses the following questions, inter alia: does central bank communication affect households’ and firms’ expectation formation and would households understand the logic behind make-up strategies such as average inflation targeting? To what extent do households and firms respond to changes in their inflation expectations by adjusting economic and financial decisions? To address these questions and to gain a better understanding of households’ and firms’ expectation formation process, Bundesbank research explores the granular information from the newly established “Bundesbank Online Panel Households” (BOP-HH) and “Bundesbank Online Panel Firms” (BOP-F), which will be discussed further in research area 2.
In addition to relying on survey-based expectations of households and firms, market-based measures of inflation and interest rate expectations are an important tool for central banks to assess the stance of monetary policy. Bundesbank research therefore develops novel approaches to measuring inflation and interest rate expectations in the euro area based on financial data. Those approaches facilitate an explicit decomposition of asset prices into expectation and risk premium components, which is particularly important at the ELB. Moreover, using high-frequency asset price information, Bundesbank research analyses whether the expectations and trading behaviour of investors change after monetary policy announcements and if these announcements convey information not only about monetary policy, but also about economic fundamentals.
In recent years, the ongoing trend towards digitalisation has led to numerous innovations in financial services, challenging traditional paradigms of the monetary system. The rapid development of privately issued digital assets and new means of payments has triggered a discussion about whether central banks should themselves issue digital currencies. Besides understanding their conceptual underpinnings, Bundesbank research empirically analyses the importance of these trends. Amongst others, ongoing work assesses the impact of monetary policy and its communication on cryptocurrency markets and prices. Moreover, research at the Bundesbank focuses on theoretical studies of consumer behaviour and demand for cryptocurrencies. These research topics complement those concerning regulatory and financial stability implications of digital currencies investigated in research area 3.
Climate change and the policies addressing it will contribute to the ongoing structural change in the euro area and the global economy. This will also have implications for the conduct of monetary policy. Increased climate-related physical risks implied by extreme weather events will likely give rise to more frequent and larger shocks, with repercussions for inflation dynamics. Additionally, policy responses that tackle climate change and aim to reduce carbon emissions will likely constitute transition risks for many sectors of the economy. This has implications for the conduct of monetary policy operations, for instance in the collateral framework or in purchase programmes. Therefore, Bundesbank research will consider the feedback effects of climate-related physical externalities and risks, but also of technological change, the transition to a net-zero carbon economy, green growth, and scarce resources on the effectiveness and implementation of monetary policy. Against this background, one major task is the extension and evolution of macroeconomic and credit risk assessment models suited to investigating these questions. This also includes the development of environmental general equilibrium models or integrated assessment models, but also a deeper analysis of the involved heterogeneities across countries and sectors.
The quick and comprehensive responses by monetary and fiscal authorities to contain the effects of the COVID-19 pandemic have once again illustrated how intertwined both policies are. Although the policy measures have averted a protracted economic crisis, they may result in unintended side effects. The fiscal policy responses to tackling the COVID-19 pandemic have given rise to unprecedented levels of public debt. Combined with monetary policy programmes that have further increased central banks’ holdings of public sector debt, this raises concerns about fiscal dominance and more broadly about the interaction of fiscal and monetary stabilisation policies. Bundesbank research therefore investigates the effectiveness of crisis measures, but also their potential side effects, especially against the background of the euro area’s fiscal framework, and their consequences for monetary and financial stability.
State-of-the-art quantitative methods are needed in order to answer the research questions above. Bundesbank research contributes to advancing the macroeconomic modelling toolkit along several dimensions. First, computationally efficient, higher-order solution and estimation techniques for dynamic stochastic general equilibrium (DSGE) models are being developed and used to quantify the impact of uncertainty on risk premiums in the economy. Second, accounting for the effects of the ELB on policy rates, or for large shocks due to the pandemic or climate change, requires non-linear, global solution methods. Third, Bundesbank research contributes to the development of econometric approaches which explicitly incorporate the ELB, are robust to outliers from the COVID-19 pandemic and account for state-dependent transitory or permanent structural changes. Finally, Bundesbank researchers advance estimation and solution techniques, applicable to large-scale models, in order to evaluate interdependencies between countries, sectors, regions and heterogeneous agents. These methods also help to link microeconomic data to macroeconomic aggregates, thus improving the micro-foundation of the models used within the Bundesbank.