Some observers make the point that, if we look at historical frequencies of cycles and recessions, it is much more likely than not that interest rates may need to return to zero at some point in the future. “Nonconventional policies” may then become part of central banks’ standard toolkit, rather than a unique exception. Second, one legacy of the crisis will be the size of central banks’ balance sheets. A central bank’s balance sheet is the foundation on which it conducts its policies, through its monopoly to create base money. An expanded balance sheet can be seen in two ways. Either as a problem because the central bank leaves too big a “footprint” on money and financial markets; and this could impair their normal functioning. Also, by holding and actively managing a portfolio of public debt, central banks take quasi-fiscal responsibilities that must be avoided. Alternatively the current situation may be seen as an opportunity, at least in times of crisis. Central banks can use their expanded balance sheet to develop a richer set of tools and better address the challenges they are facing. Finally, the pre-crisis, inflation-targeting regime, was closely associated with the “Great Moderation” when inflation was low and output growth stable. This period of sustained growth and limited volatility was considered normal at the time. We know now that it was very exceptional from a historical perspective.
However, long periods of low interest rates unavoidably create incentives for risk taking and “search for yield”. That dilemma can, in principle, be solved through proper macroprudential policies. I will return later to challenges we face in that specific area. The meaning of price stability Let me start with a crucial point. Central banks have a strong mandate to preserve and achieve price stability. Strict adherence to this mandate – and the clear willingness to fulfil it – is their main protection against the dangers created by the zero lower bound. As we all know, inflation is ultimately driven by expectations. Inflation expectations were remarkably stable during the whole first decade of the euro. Today, the major risk in the euro area is a downward drift that would durably set long-run inflation expectations at a level below our objective of price stability. We do not know much about how expectations are formed. However, I have no doubt  BIS central bankers’ speeches  1  that the perceived reaction function of the central bank plays a major role in anchoring price stability. Second, symmetry is of the essence. For a significant period of time, we have been well below our definition of price stability in the euro area, both in terms of effective inflation and long-term expectations. There is a temptation to take a benign view of this situation and consider that low inflation is beneficial per se, irrespective of its level.