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A common euro area fiscal policy could prevent low inflation traps associated with 'Japanification' from taking hold even after monetary policy has run out of room to cut interest rates, a research paper published by the European Central Bank argues.
Low-inflation traps occur when actual and expected inflation are consistently below the central bank's target just as as nominal interest rates are close to or at their lower bound. They can become self-fulfilling when the private sector believes inflation will stay low in future.
National governments can beat the trap if they signal their willingness to increase spending by whatever amount is needed to more than offset the effects of a possible drop in private sector confidence, author Sebastian Schmidt argues. "Preventing self-fulfilling low-inflation traps could be another reason to create a central fiscal capacity in Europe," he concludes.