The policy mix, when monetary policy is constrained at the zero lower bound

The scope of macroeconomic policy making in the euro area is being intensely debated. Decision makers confront the challenge of a persistently slow and fragile economic recovery where policy efforts are unequally distributed across available instruments. Aggregate demand growth remains sluggish and inflation well below target despite the fact that monetary policy rates are at the zero lower bound (ZLB) and that the European Central Bank has employed a wide range of conventional and unconventional policy measures. At the same time, national fiscal policies are expected to stay within the perimeters of commonly agreed EU rules, namely the Stability and Growth Pact, while progress with structural reforms could be accelerated. This section analyses the macroeconomic policy mix of the euro area at the current juncture. It first reviews the monetary policy stance by looking at two measures in the context of a low demand and low-inflation environment keeping in mind the degree of uncertainty of such an exercise: the shadow policy rate, which is the theoretical negative rate that would prevail if there were no lower bound on interest rates; and the equilibrium interest rate, the real rate at which inflation would be stable. Second, it takes a look at fiscal policy making by focusing on both the stance of the euro area as a whole and differences between Member States. The section concludes with an overall assessment of the macroeconomic policy mix. Our analysis suggests that while equilibrium interest rates experienced a significant decline in recent years, the current monetary policy stance of the ECB as measured by shadow rates appears to be very accommodative. However, monetary policy has already provided considerable support and cannot carry the full burden of the policy effort nor address country-specific issues. Consequently, there is a need to pay more attention to fiscal policy in terms of both its aggregate stance and its composition and use in different euro area countries, naturally within the limits of the Stability and Growth Pact.