However, in the face of deflationary shocks driving inflation below its target and leading the central bank to cut its interest rates, these may ultimately “collide” with their lower bound. This asymmetry makes monetary policy potentially more effective in combating inflation than in combating deflation or, even, persistently low inflation. A dangerous vicious circle may be created as a result. In a setting in which central banks’ hands are expected to be frequently tied by the lower bound on interest rates, economic agents will with good reason expect any inflation overshooting to be corrected swiftly, but no so for undershootings. Therefore, average expected inflation over a long period will tend to run below target. Given that in the long run the nominal interest rate is the real equilibrium interest rate plus expected inflation, a fall in the latter implies lower average nominal rates, causing these to collide with their lower bound more often. This entails less headroom to provide stimulus in recessions with low inflation, further lowering inflation expectations, and so it continues. In this setting of historically low natural rates, a loss of interest rate policy scope and risk of a deanchoring of inflation expectations, the major central banks have deemed it necessary to rethink their monetary policy strategy, i.e. how they express their monetary policy targets and how they pursue them with the tools available.
From a broader perspective, the introduction of the PEPP – and the June and December expansions, which increased the maximum volume of net purchases to € trillion – led to a period of gradual easing of financing conditions in the euro area, not only for sovereign debt, but also other market segments such as corporate debt. In addition, according to analysis by the Banco de España, the PEPP is having a markedly favourable impact on GDP growth and inflation in the euro area.1 This easing has been essential for providing fiscal authorities in all countries in all euro area countries with room for manoeuvre, which has allowed them to deploy the measures to support the income of households and firms that I have mentioned earlier. In addition to the PEPP, another key instrument in the monetary policy response during the crisis are the TLTROs. This programme affords banks funding under particularly advantageous conditions, provided they meet certain targets in terms of lending to firms and households (excluding, in the latter case, loans for house purchase). With the onset of the pandemic, this programme was modified to make it even more attractive to banks, enabling them to obtain funding at an interest rate that could temporarily be as low as -1%, on the condition that they do not reduce their volume of eligible lending in light of the pandemic crisis. This instrument has also proved very effective.