When the last crisis broke out, central banks slashed interest rates, which rapidly reached near-zero levels In some cases, such as that of the European Central Bank (ECB), rates even turned negative. In this context, central banks had to implement a series of novel, or “unconventional”, measures. These measures included asset purchase programmes, medium- and long-term lending to the banking industry under advantageous conditions, and announcements about the future course of monetary policy, known as forward guidance. The empirical evidence shows all these measures to have been effective at cushioning the impacts of the economic crisis and supporting the subsequent recovery, and they now form part of central banks’ toolkit for the future. Against this background, what scope is there for monetary policy action in the event of a future crisis? As the inflation outlook improves in the future, interest rates may be expected to rise gradually towards their long-term equilibrium rate. The distance between this level and the effective lower bound on interest rates – i.e. the level below which further rate cuts would be counter-productive as a means of stimulating the economy – will determine the future scope for conventional monetary policy. We now know that the lower bound on interest rates in the euro area is not zero, as was traditionally believed, but a negative number which, although difficult to quantify, is probably not far below the current deposit facility rate of 0.40%. Economic theory and the empirical evidence suggests that demography is one of the factors underlying the long-term interest rate.
The financial collapse in Russia, deepening recession in Japan, the long battle – then sudden defeat last week – in Brazil’s attempt to hold its exchange rate, and fluctuating fears of possible knock-on effects on the major countries’ financial markets all contributed to an increased sense of financial fragility, which has not been easy to contain. We can, I believe, still avert a more general international financial upheaval (and the financial markets’ response to the latest developments in Brazil, as well as the beginnings of a recovery in capital flows to some countries in Asia, are reasonably encouraging in this respect). But, we are nevertheless bound to see a pronounced slowdown of world economic activity. The IMF has cut its latest (December) forecast for world growth to less than 2¼% in 1998/1999. And the risks almost certainly remain on the downside. That’s still not global slump or recession. But large parts of the world economy are in fact in recession and the prospect for the world as a whole turns very much on what happens in the major industrial countries. In essence, what we are seeing is a sharp cutback in capital flows to much of the emerging world and to some of the transition economies, enforcing on those countries a corresponding cutback in domestic demand and creating the need for an urgent improvement in their current accounts.