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Economic policymaking under uncertainty

Speech by Peter Praet, Member of the Executive Board of the ECB, at the “la Caixa” Chair for Economics and Society conference, Madrid, 17 October 2018


Today I would like to reflect on the consequences of population ageing for economic policy making. It may sound at odds with the title of my remarks – “Economic policy making under uncertainty” – because demographic developments are to a large extent predictable over the short to medium run. Yet population ageing has pervasive implications for policymaking, in particular for the reform of public pension systems and the effectiveness of macroeconomic policies.

Population ageing is a challenge for the sustainability of public finances and monetary policy. High levels of public debt combined with significant implicit public pension liabilities risk leaving little room for fiscal policy to tame business cycles. In combination with other secular economic trends, population ageing has been exerting protracted downward pressure on real interest rates. As a consequence, central banks are more likely to hit the effective lower bound on policy rates, constraining the ability of standard monetary policy instruments to carry out macroeconomic stabilisation.

The euro area, in common with other advanced economies, has entered an era of demographic change.[1] Declining fertility rates and rising life expectancy are increasing the number of pensioners relative to workers. The European Commission projects the old-age dependency ratio to rise from about 30% to over 50% by 2070, with the bulk of the increase taking place in the next two decades. In other words, while today each pensioner is supported by approximately three workers, by 2070 there will be just two workers for each pensioner.

One salient feature of the economic environment in advanced economies has been the steady decline of short and long-term nominal interest rates over several decades to the extremely low levels that currently prevail. Since their peaks in 1981, long-term nominal interest rates have declined by about 13.8 percentage points in the United States and 10.8 percentage points in Germany. While the bulk of this decline is related to central banks successfully re-anchoring inflation expectations, population ageing has contributed to a decline in the labour supply, a slowdown in productivity growth, and higher precautionary savings, thereby exerting downward pressure on potential growth and the so-called equilibrium real rate of interest.[2]

The generalised impact of ageing is exacerbated at present by the demographic effect of the baby-boomer generation. This large cohort remains in the saving part of its life cycle and is likely to exert downward pressures on real interest rates until the end of the coming decade. The impact of ageing on the real interest rate has been compounded by other important macro-economic trends, in particular risk aversion and flight to safety.[3]

This brings about a number of challenges for three policy area that I will consider in turn, fiscal policy, monetary policy and structural policy.

Policy challenges from population ageing

Fiscal policy

Population ageing will have a deep impact on public finances in the euro area for decades to come. Policy can react to this challenge in several ways. First, reforming social security systems to prevent population ageing from increasing age-related expenditure. Second, fiscal consolidation outside of social security systems to finance the rise in age-related expenditure. Third, doing nothing and letting the increase in age-related expenditure feed fully into higher public debt. The latter – what could be called the procrastination strategy – is very risky for countries that start with high public debt.

Indeed, initial conditions are not comfortable in a number of euro area countries. Public debt ratios have risen strongly in the aftermath of the financial crisis, leaving little room for cushioning the impact of population ageing via additional debt. High public debt ratios have already limited the room for fiscal stabilisation in a number of countries.

The increase in age-related expenditure may not look large at first sight. The European Commission’s 2018 Ageing Report projects the public age-related costs in the euro area to increase by 1.1 percentage points of GDP between now and 2070. Yet, the increase will be twice as high in the early 2040s.[4] This does not look very large, considering that euro area countries already spend on average more than a quarter of their GDP on age-related public expenditure. However, if left unaddressed these additional annual costs will snowball into very large amounts over a long horizon. Illustrative debt simulations show that the impact of the rise in age-related cost on the euro area public debt to GDP ratio would be of the order to 50 percentage points by 2070. Rather than declining, the euro area public debt ratio would rise well above 100%, with considerable differences across countries. Leaving age-related costs unaddressed could thus fuel doubts about debt sustainability, which in turn would pose risks to the economy at large. Even more so if previously agreed sustainability-enhancing pension reforms were to be reversed.

There are two reasons calling for policy action sooner rather than later to address age-related costs. First, the bulk of the age-related cost increase is expected to take place during the next two decades, in which the baby boom generation will enter retirement. Incidentally, this is true for many countries that currently have high debt ratios.

Second, estimates of future age-related costs themselves are surrounded by a high degree of uncertainty, with risks tilted towards stronger increases than assumed in the baseline of the Ageing Report. The Ageing Report projections are based on somewhat favourable macroeconomic and demographic assumptions. If these assumptions were not to materialise, age-related costs could be substantially higher. To capture some of the uncertainty, the Ageing Report includes several adverse risk and sensitivity scenarios, which indeed suggest higher cost pressures.  One risk scenario implies higher costs for health and long-term care, on grounds of the increased use of expensive medical equipment and of a stronger upward convergence in living standards. In this scenario the increase in total age-related costs would be more than twice as large as in the baseline by 2070. A lower total factor productivity growth rate than assumed in the baseline projections would also imply considerably higher costs in the long term.

The call for early policy action does not mean that action needs to be the same across countries. The appropriate course of action should reflect deep societal preferences. Some countries may favour reforms to entitlements and boosting private-sector provision of pensions beyond what has already been achieved. Other countries may favour linking retirement age to life expectancy, while maintaining the pension benefit ratio of the system. Yet other countries may opt for higher contribution rates, although this may put a strong burden on younger generations. These options are not mutually exclusive and can be implemented in combination. When designing pension reforms it is also important to be mindful of their possible implications for the supply side of the economy, as higher levels of potential growth are essential to improve social welfare.

Political pressures to delay reforms, to discontinue an existing reform agenda – or to even undo previous reforms – unfortunately persist, despite the strong and well-documented case for pension reforms. One of the important challenges for fiscal policymakers is how to avoid uncertainty arising from reform reversal. This should be an important consideration when designing reforms. From this perspective, a promising approach would be to automatically link the retirement age to changes in life expectancy, as is already the case in a number of countries. This would make pension parameters more predictable, and – by avoiding putting pension adequacy at risk – hopefully less prone to policy reversal. Irrespective of the design of reform, it will be important to ensure fair burden-sharing across generations. This will help to increase the social acceptance of pension reforms. Raising the public’s awareness of the ageing-related challenges ahead of us and the need to act today remains an important task for policymakers.

Monetary policy

With demographic factors expected to continue to exert downward pressure on real rates, growth-enhancing structural reforms are essential for a durable rise in equilibrium real rates. Such actions would support monetary policy in its efforts to maintain price stability and strong macroeconomic performance in an environment of low equilibrium interest rates.

Indeed, low equilibrium real interest rates affect the monetary policy stance in two ways: first, any given policy rate is less stimulatory with lower equilibrium rates. Second, the policy rate is likely to hit the lower bound much more frequently than thought possible in the past – a direct consequence of the fact that current estimates of the real equilibrium interest rate are much lower than the 2% estimate customary before the great financial crisis. These effects could have implications for the way the economy and prices evolve through time; recessions may last longer, and recoveries may be slower and shallower, with a higher risk throughout of missing the objective.

Academics and policymakers have reflected widely on the policy implications, and suggested a number of potential alternative monetary policy strategies to cope with a low equilibrium rate of interest. Each alternative strategy has advantages and disadvantages.

For example, some prominent economists have advocated raising central banks’ inflation targets. A higher steady-state inflation rate would generate higher levels of nominal interest rates and so deliver greater headroom to use conventional interest rate policy in downturns. Indeed, a higher target could reduce the frequency and duration of periods where policy rates are at their effective lower bound. Yet raising the inflation target is not costless. One concern is the potential for increased uncertainty that can make household and business decisions less efficient.[5] Raising the inflation target forces societies to bear the costs of higher inflation at all times.[6]

Moreover, central banks have invested significant reputational capital over the past quarter of a century to cement the credibility of their inflation targets. Actively disavowing and reversing the results of those efforts would likely be detrimental to long-term inflation expectations and the credibility of central banks in general. The ultimate outcome could be heightened uncertainty and lower real growth.

An alternative monetary framework is price-level targeting. Under this framework, a central bank tries to keep the level of prices on a steady path, say rising by 2% each year. This strategy implies the central bank aims to make up for past inflation target misses by engineering inflation deviations in the opposite direction.

Consider a central bank that brings its policy interest rate to its lower bound, due to sharp negative demand shocks and rapid disinflation. Under price-level targeting, market participants and the public at large would expect that the current undershoot of inflation will lead in the future to looser policy and inflation above target for as long as necessary to bring the price level back to its targeted trend. These expectations of interest rates being “lower for longer” and, therefore, of higher inflation help reduce real interest rates during the downturn, despite the inability of the central bank to cut the nominal policy rate much below zero. Overall, expectations of future offsetting measures act as effective automatic stabilisers in disinflationary recessions.

Leaving aside the difficulty of communicating this strategy to the public, this approach risks policy mistakes in the presence of cost-push shocks. Typically, optimal policy exercises recommend central banks “look through” cost-push shocks that only temporarily drive up inflation. Under a flexible inflation-targeting regime with a medium-term orientation, policymakers are advised to ignore the initial surge in inflation and calibrate policy to counteract any longer-term impacts on inflation that may occur once the temporary effects of the cost-push shocks on inflation have faded. By doing so, they would be able to minimise the adverse consequences of the cost-push shock for output and unemployment.

By contrast, under price-level targeting, the central bank would have to reverse all the effects of cost-push shocks on the price level; “bygones” are not considered “bygones”, no matter the source of past target misses. This action would likely magnify the negative effects of the cost-push shocks on output and employment.

Bernanke recently proposed a variant of a price-level targeting regime.[7] Under this variant, the central bank would behave in normal times as a flexible inflation targeter, seeking to stabilise inflation – not the price level – over a medium-term horizon. But when interest rates become stuck at their lower bound, the central bank would switch to a commitment to bring back the price level to a certain trend. During those periods, the central bank would promise a lower-for-longer rates policy meant to engineer a period of inflation higher than target in the future in order to compensate for the near-term shortfall in inflation.

Such a regime-switching arrangement would amount to applying the price-level commitment only in the face of sufficiently severe negative demand shocks, making the price-level targeting framework more robust to the pitfalls of cost-push shocks. Would communication become easier too? Most likely not. Explaining the rationale and the mechanics of the switch from one targeting regime to another would not be a simple task for the central bank.

When considering the proposals put forward in this debate, lessons should also be drawn from the experience of central banks dealing with the zero-lower bound in recent years. The main lesson is that monetary policy can retain traction even when constrained by the effective lower bound. The non-standard measures introduced by major central banks over the past decade proved to be highly effective in supporting economic activity and a gradual return of inflation to its objective. Such measures have featured quantitative easing through asset purchases, negative interest rates on reserves, forward guidance and a number of credit-easing instruments meant to restore transmission. These measures, especially when combined together, did enhance the scope for central banks to engineer very accommodative financial conditions through their effects on a wide range of maturities and on a wide spectrum of assets that are relevant for the transmission of monetary policy.

Conventional monetary policy influences the stance mainly through pinning down the level of the short end of the yield curve, by shifting the overnight interest rate. The unconventional instruments deployed during the crisis reinforced the desired effect by shifting the slope and curvature of the yield curve.

Looking into the future, our forward guidance on rates and re-investment policy offer an effective combination of instruments to support a durable return of inflation to below, but close to, 2%.

Structural policies

While unconventional monetary policy can be used to overcome challenges from low equilibrium interest rates, we should be wary about permanently placing a large burden on central banks to deploy tools to counter problems that are ultimately caused by structural economic and financial inefficiencies. The responsibility to address the forces depressing potential growth resides with structural policies, not with monetary policy.

There are three fruitful areas for reform: mitigating the impact of demographics on the labour force and public finances, boosting productivity growth and supporting efficient financial markets.

The demographic trends in Europe are fairly fixed, but structural policies can effectively mitigate their impact on the labour force and public finances. These include reviewing pension eligibility, in particular the retirement age, the income replacement ratio of pensions, and how they are funded. But they also extend to labour market policies more generally. Policies that encourage labour force participation can act to mitigate the rise in the dependency ratio and those that support human capital accumulation across age cohorts can boost investment rates and sustain the productivity of older age cohorts.

With the likely fall in working-age population, raising productivity is a fundamental challenge for euro area countries. Higher productivity growth makes the future pension liabilities that currently exist more affordable, provides greater fiscal space and should increase real equilibrium rates, providing more space for monetary policy to use conventional interest rates for macroeconomic stabilisation

Structural policies can help in various ways: strengthening competition amongst firms and improving the business environment can increase incentives to innovate and invest in human and physical capital; institutional reforms increasing the efficient functioning of public administration can support investment; reforms enhancing labour mobility and reducing skill mismatches through training support the diffusion of technology and growth prospects for innovative firms.[8] Providing a strong institutional framework[9] reduces uncertainty and so encourages businesses to invest in new productivity-enhancing technology.

Productivity is more a question of how firms set up the production process than how much is produced. There are two margins of productivity that are important: the creation of innovation and its diffusion. OECD analysis on firm-level data finds that global leaders – those firms at the productivity frontier – have increased their productivity gap relative to low-productivity firms over time, and especially so in the services sector.[10] This implies that knowledge diffusion should not be taken for granted.

Future growth will largely depend on our ability to revive productivity diffusion, both within and across countries. A reform agenda entails four main elements. First, support trade and international investment with a view to adapt to and to learn from global firms at the productivity frontier. Second, design policies which can encourage new entrants in the market with a focus on new technologies and business models. Third, foster investment in innovation, including research and development. Finally, support the upskilling and reskilling of the workforce, which can reap the benefits from innovation and accommodate the need for job reallocation. Investment in education and skills is particularly important to ensure that workers have the capacity to make the most of digitisation and to adapt to changing technologies and working conditions. Skills and productivity are the real sources of strong, inclusive and sustainable growth.

The third area where structural reforms can help is supporting efficient financial markets. Completing Banking Union and implementing the proposed plan for a Capital Market Union in Europe would further support a better allocation of funding, achieve a better risk sharing outcome and support long-term growth.


Population ageing will continue to have pervasive implications for fiscal, monetary and structural policies, in particular until the baby-boomer generation moves to the dis-saving part of its life cycle at the end of the coming decade.

Population ageing comes with well-known challenges for fiscal policy, but also brings about specific challenges for monetary policy that are related to the effective lower bound on policy rates. The downward trending of equilibrium real rates of interest makes it more likely for central banks to hit that bound.

While monetary policy can cope with such developments by adjusting the conduct of interest rate policies and, when needed, resorting to unconventional instruments, growth-enhancing structural reforms would exert upward pressures on equilibrium interest rates. This would not only increase the room for manoeuver of macroeconomic policies, but also support higher sustainable levels of economic welfare.

  1. [1]Lee, R (2016), Macroeconomics, Aging, and Growth, Volume 1B of Handbook of the Economics of Population Aging, chap. 7, 59–118, Elsevier.
  2. [2]Krueger, D & A Ludwig (2007), “On the consequences of demographic change for rates of returns to capital, and the distribution of wealth and welfare,” Journal of Monetary Economics, 54(1): 49–87; Carvalho, C, Ferrero, A & F Nechio (2016), “Demographics and real interest rates: Inspecting the mechanism,” European Economic Review, 88: 208–226; Gagnon, E, Johannsen, B & J D Lopez-Salido (2016), “Understanding the New Normal: the role of demographics,” FEDS Working Paper; 2016-080; Bielecki, M, Brzoza-Brzezina, M & M Kolasa (2018), “Demographics, monetary policy and the zero lower bound,” National Bank of Poland Working Paper No. 284; Lisack, N, Sajedi, R & G Thwaites (2017), “Demographic Trends and Real Interest Rates,” Bank of England Working Paper 701.
  3. [3]Del Negro, M, Giannoni, M, Giannone, D & A Tambalotti (2017), “Liquidity, and the Natural Rate of Interest”, Brookings Papers on Economic Activity, Spring, 235-316; Neri, S & A Gerali (2017), "Natural rates across the Atlantic," Temi di discussione (Economic Working Papers), 1140, Bank of Italy.
  4. [4]See European Commission (2018) “The 2018 Ageing Report: Economic and Budgetary Projections for the EU Member States (2016‑2070)”. The 2018 Ageing Report, published on 25 May 2018, is the latest of the reports prepared every three years by the Ageing Working Group of the Economic Policy Committee.
  5. [5]Cecchetti and Schoenholtz (2015) report that: “In a sample of more than 100 countries, we see that a one-percentage point addition to average inflation is associated with a ½-percentage-point rise in the annual standard deviation of inflation.”
  6. [6]Woodford (2003) Interest and Prices, Princeton University Press
  7. [7]Bernanke (2017) Monetary Policy in a New Era
  8. [8]Masuch, K, Anderton, R Setzer, R & N Benalal (eds.) (2018): “Structural Policies in the Euro Area,” ECB Occasional Paper, No. 210; and, more specifically, reducing product market regulation and enhancing competition can increase firm churning (ie, higher firm entry and exit rates) which, in turn, increases total factor productivity (see Anderton, R., Jarmulska, B., and Di Lupidio, B. (2018), “Product market regulation, business churning and productivity: evidence from the European Union countries”, GEP Research Paper 2018/12, University of Nottingham
  9. [9]Masuch, K, Moshammer, E and B Pierluigi (2016), “Institutions, public debt and growth in Europe”, ECB Working Paper Series No. 1963 and Consolo, A, Pierluigi, B & F Malfa (2018), “Insolvency frameworks and private debt: an empirical investigation”, ECB Working Paper Series, forthcoming.
  10. [10]OECD (2015), The Future of Productivity, OECD, Paris.

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