[FRANKFURT] A perception that a central bank is close to the limit of how far it can cut interest rates tends to weigh on inflation, making it harder to lift price growth back to target, a research paper published by the European Central Bank showed on Monday.
The ECB has been battling with the limit of its interest rate policy for some time. Desperate to boost inflation, it has cut its deposit rate twice since December, rowing back on a long-standing pledge that interest rates had reached their lower bound.
It now argues that rates could still go lower, if needed, though policymakers admit that the room for further cuts is limited.
"The possibility that future adverse shocks will force the central bank to lower the policy rate to its effective lower bound (ELB) gives rise to a downward bias in inflation expectations by creating tail risk in future inflation," said the paper, also published by the US Federal Reserve.
The ECB, which is also buying 80 billion euros worth of assets, said last week rates will stay at current or lower levels for a long time.
The risk of hitting a constraint on rates could cause inflation to undershoot the target by as much as 45 basis points, said the authors, whose views do not necessarily represent those of the ECB or the Fed.
The perception that rates will hit a constraint reduces expected marginal costs for forward-looking firms, who will then already lower their prices even when the policy rate is not yet at their bottom, the paper said.
"The effective lower bound thus weighs on current inflation outcomes through private sector expectations even if the policy rate is currently not constrained by the lower bound," it said.
The ECB has missed its inflation target of close to 2 per cent for three straight years and forecasts show it will continue to miss it for at least three years.
"Our model suggests that achieving the inflation target may be more difficult now than before the Great Recession, if the recent lower bound experience, together with the recent downward assessment of the long-run growth rate of the economy and long-run equilibrium policy rate, have made the private sector to increase its assessment of the likelihood of hitting the ELB in the future," it said.