Monetary policy in Europe is facing problems which, until the Great Recession, did not really exist.
1. Inflation is too low
2. Interest rates on bank reserves are negative
3. Money supply increase is unprecedented
The head of the ECB, Mario Draghi, said on Friday that the economic situation warrants further monetary easing.
With interest rates on reserves already negative, the ECB may increase its quantitative easing program. In recent months the ECB has been buying 60 billion euro a month of mostly government bonds. It seems it is not enough; inflation in the Eurozone last month was 0.1%. The ECB target is inflation of just under 2%.
In the past, central banks worried about inflation being too high. Now they have two worries
1. Inflation is too low
2. It is hard to raise the inflation rate.
What is the problem with low inflation? Inflation expectations are also low, limiting how much the real interest rate can be reduced
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