Governor Olli Rehn
Bank of Finland

Warwick Economics Summit 2021
Video Message, 5.2.2021

Session “Cooperation between monetary and fiscal policies to mitigate the economic impacts of the Covid-19 pandemic”


Ladies and Gentlemen, Dear Colleagues,

It is a great pleasure for me to speak at the Warwick Economics Summit 2021 today. Let me commend the organisers for the choice of the topic of this session – cooperation and indeed interaction between monetary and fiscal policies is one of the distinctive features of the mostly successful policy response to the Covid-19 crisis.

In my brief remarks, I will focus on two themes. First, I will discuss the policy response to the Covid-19 pandemic. Second, I will provide you with some views on the monetary policy strategy review of the European Central Bank that is currently underway.

Economic policy response to the Covid-19 crisis has been swift and aggressive on a broad front. The ECB’s monetary policy of is strongly accommodative, as is the fiscal policy of the euro area states. There are two observations regarding the crisis response that I want to highlight.

First, the policy mix. The devastating economic fallout from the Covid-19 pandemic, combined with constrained policy space, forced monetary and fiscal authorities to join forces and pull together. In these exceptional circumstances, the key role of monetary policy is to ensure favourable financing conditions, while the task for fiscal policy is to boost demand.

Due to the severity of the shock, very forceful fiscal measures are justified to limit persistent damage to our economies and jobs. The crisis response has clearly demonstrated how monetary policy and fiscal policy can be mutually reinforcing.

Second, it is noteworthy that national fiscal responses are being augmented at EU level. The EU’s 750 billion euros recovery instrument – NextGenerationEU – will help mitigate the economic and social impact of the Covid-19 pandemic, while at the same providing funding for investments to make EU economies more sustainable and better prepared for the necessary green and digital transitions.

Most importantly, the breathing space provided by the highly accommodative policy mix should be utilised wisely to ensure an enduring economic recovery. European policymakers should seize the opportunity for structural transformation and accelerate the needed transition to lower carbon dependence. This is critical also for securing longer term fiscal sustainability in the face of increasing public debt.

Let me next turn to the ECB’s monetary policy strategy review.

The underlying reason for the strategy review is the profound structural changes of the euro area and the world economy. These include the change in the relationship between the spare capacity of the economy and inflation, the fall in the natural interest rate, and sluggish productivity growth. A reassessment of the ECB's monetary policy strategy is all the more important given the damage wrought by the Covid-19 pandemic.

The long-term decline in natural interest rates has left less room for interest rate cuts with the effective lower bound laying the floor, although the so-called unconventional monetary policy measures have been able to alleviate this constraint to some extent.

One of the key issues of the review is the question of correctly anchoring inflation expectations. While our formulation of the inflation target – below but close to 2 percent – was fit for purpose in driving down higher-than-desired inflation in the early 2000s, it has also generated a perception of asymmetry and ambiguity of the target. In the current environment of chronically low inflation, this ambiguity is hampering the effectiveness of monetary policy.

Therefore, to succeed in fulfilling our mandate and it is critical that we make sure the inflation target is understood as symmetric by the public. In my personal view, there are two components to accomplish this. First, we need a clear and genuinely symmetric definition of price stability target. Second, we need a reaction function that delivers sufficiently forceful and equally effective policy actions to deviations from the target to both directions. In a world where the economy faces the effective lower bound more often than in the past, the way to guide longer term inflation expectations up to the target is to allow actual inflation to exceed the target for some time following periods of persistently low inflation.

Overall, the strategy review needs to cover a wide range of topics and be supported by thorough analyses of the forces that drive inflation dynamics today. As policymakers, we need to base our decisions on both economic theory and empirical evidence, and remain open to fresh thinking.

As an example, let me mention two different interpretations of the impact of global megatrends on the natural interest rate and future inflation. Based on an empirical analysis employing historical data on Europe, Oscar Jordà, Sanjay Singh, and Alan Taylor argue that pandemics, like Covid-19, have long-lasting negative effects on the natural rate, reflecting a lack of needed investment, an increased desire to save, or both.[1]

On the other hand, in a recent book Charles Goodhart and Manoj Pradhan reach an opposite conclusion.[2] They argue that global population aging and worsening dependency ratios around the world, not least in China, lead to increased inflation pressures through multiple channels, including labour shortages driving up the bargaining power of labour relative to capital, a larger share of non-productive population dampening deflationary pressures, and increased health care expenditure needs.

Based on comparative probability analysis, my view is closer to the low-for-long narrative with the focus on very low inflation expectations. Nevertheless, I found Goodhart and Pradhan’s argumentation refreshing. Whether or not their predictions will hit the mark is another issue. It is important that critical questions are raised and backed by analysis. This will force reflection on widely held assumptions on future developments.

Indeed, the continuous evolution of our operating environment – not to speak of potential reversals in some global megatrends – is a compelling reason for the ECB to regularly review its monetary policy framework, for instance every five years. This would enable us to recognise the impacts of key structural developments on the operating environment and allow us to regularly revisit our strategy as appropriate so that monetary policy may remain fit for purpose.

Let me conclude. Faced with an unprecedented blow to the global economy, monetary and fiscal policymakers have had to join forces to deliver a crisis response commensurate with the shock. Forceful policy measures have been justified to limit persistent damage to our economies. Effective fiscal and monetary policy support should be continued until the recovery of economic activity is firmly underway.

At the same time, Covid-19 has highlighted the impact of longer-term structural trends that policymakers need to pay attention to. This holds for the ECB’s monetary policy strategy as well. I underlined the importance of carefully reformulating our inflation target in the current “lowflation” environment. With the help of the strategy review of the ECB’s monetary policy can better support sustainable growth and employment and help achieve the inflation target in the euro area in the coming years.

I will stop here and wish you all a great conference and inspiring discussions. Stay safe and healthy!

[1] Jordà, Ò., S. R. Singh, and A. M. Taylor. 2020. “Longer-Run Economic Consequences of Pandemics.” Covid Economics: Vetted and Real-Time Papers 1 (April 3): 1–15.

[2] Goodhart, C A E and M Pradhan (2020), The Great Demographic Reversal. Aging Societies, Waning Inequalities, and an Inflation Revival, Palgrave Macmillan.