to promise to keep interest rates low for longer in the future. Such commitments, if credible, lower longer-term interest rates and provide economic stimulus even if the current interest rate remains unchanged.9While forward guidance is a useful instrument, recent research has highlighted that its effectiveness can be improved if combined with other non-standard monetary policies.10 Research in both academia and in central banks has therefore re-examined alternative monetary policy tools, including so-called quantitative easing (QE) policies. And here the newly developed models with financial frictions have been useful.11 Earlier studies based on the assumption of frictionless financial markets had concluded that QE is completely ineffective. The renewed focus on financial frictions clarified that this conclusion is unwarranted, once it is recognised that financial intermediaries are subject to leverage constraints.12 Large-scale asset purchases can ease these constraints and increase investors’ risk-bearing capacity, leading to a portfolio rebalancing towards risky assets and to strengthened lending activity for banks. All in all, research has confirmed that central banks are not powerless at the effective lower bound. Provided they are willing to explore non-standard policy avenues, they can continue pursuing their price stability mandates even in the most adverse circumstances. The evolution of policymaking The policy response by central banks and governments has evolved along the two main lines suggested by research.
As short-term interest rates approached the effective lower bound, central banks on both sides of the Atlantic undertook a number of unconventional measures aimed at influencing the whole constellation of rates that are important for the financial decisions taken by households and businesses. Forward guidance helped guide market expectations of future short-term rates. QE involved direct intervention by central banks in markets through large scale asset purchases to influence the yield curve beyond the very short term. A large body of empirical research has substantiated the success of these policies in supporting the economy and inflation, both in the euro area and in the United States.13 But central bank policy moves extended beyond just measures to counteract the impairment of the transmission mechanism caused by financial frictions. The ECB also acted in various ways to prevent self-fulfilling expectations from delivering socially undesirable outcomes by coordinating expectations onto “good” outcomes. One such policy initiative was our lender-of-last-resort intervention during the financial crisis. Revisiting the Bagehot principles set out a century and a half ago in the light of the ongoing crisis,14 the ECB lent freely to solvent financial institutions against sound collateral, penalised by a haircut. We did so in multiple ways: our liquidity operations moved to a fixed rate full allotment basis with unprecedented maturity of four years, and we widened the eligible collateral accepted in our operations.