Demographics, monetary policy, and the zero lower bound

The recent literature shows that demographic trends may affect the natural rate of interest (NRI), which is one of the key parameters affecting stabilization policies implemented by central banks. However, little is known about the quantitative impact of these processes on monetary policy, especially in the European context, despite persistently low fertility rates and an ongoing increase in longevity in many euro area economies. In this paper we develop a New Keynesian life-cycle model, and use it to assess the importance of population ageing for monetary policy. The model is fitted to euro area data and successfully matches the age profiles of consumption-savings decisions made by European households. It implies that demographic trends have contributed and are projected to continue to contribute significantly to the decline in the NRI, lowering it by more than 1.5 percentage points between 1980 and 2030. Despite being spread over a long time, the impact of ageing on the NRI may lead to a sizable and persistent deflationary bias if the monetary authority fails to account for this slow moving process in real time. We also show that, with the current level of the inflation target, demographic trends have already exacerbated the risk of hitting the lower bound (ZLB) and that the pressure is expected to continue. Delays in updating the NRI estimates by the central bank elevate the ZLB risk even further.