Monetary Policy in Perspective

Podcast: LSE: Public lectures and events
Date: February 4, 2026
Host: Ricardo Reuss (LSE)
Speaker: Klaas Knot (Former President, Dutch Central Bank)

Overview

In this insightful lecture inaugurating the CFM-RCM Lecture Series, Klaas Knot reflects on his 14 years as President of De Nederlandsche Bank (DNB) and a member of the ECB Governing Council. He delivers a candid post-mortem on the key episodes that shaped recent European monetary policy: the Eurozone debt crisis, the prolonged low-inflation trap, and the high-inflation episode following COVID-19 and the Ukraine war. Knot distills vital lessons for the future, examining the real-world complexities of central banking, the limits of theory, and the critical role of institutional design, expectations, and credibility.

Key Discussion Points and Insights

The Three Episodes: Crisis, Low Inflation, High Inflation

[03:00]

• Knot structures his 14 years into three distinct episodes:
  • Eurozone Debt Crisis (2011–2012):
    First meeting at ECB coincided with one of three interest rate hikes; this optimism was short-lived due to Greece’s crisis and subsequent full-blown euro crisis.
  • Low-Inflation Trap (2013–2020):
    Post-crisis, challenge shifted to persistently low inflation, hard to exit.
  • High-Inflation Shock (2021–2025):
    Abrupt switch post-pandemic and war; in Knot’s words:

    "Our target was 2%. Well, I can assure you there was exactly one month in which it hit our 2% target. That was September 2021." [04:47]

• No academic preparation could fully anticipate the need for on-the-fly solutions and innovations required in this period.

Original EMU Architecture and Its Structural Flaws

[06:16]

• The EMU was based on the principles:
  • Centralized monetary, decentralized fiscal policy.
  • ECB independence, Bundesbank-style focus on price stability.
  • Stability and Growth Pact for fiscal discipline and a strict “no bailout” clause.
• This architecture failed during the crisis, quickly proving unsustainable given financial interlinkages.

Anatomy and Lessons from the Eurozone Crisis

Liquidity Problems and Capital Flight
[13:10]

• In a crisis, normal interbank lending halted; ECB’s balance sheet ballooned as ECB became "central counterparty" for euro area liquidity.
• Capital could easily and quickly flee within the monetary union, exacerbating peripheral stress.

Fragmentation in Monetary Transmission
[19:00]

• Single ECB policy rate but divergent yields across countries:
  • “The spread question is never far away... it’s always around the corner.” [23:13]
  • Core (e.g. Germany) had low yields; periphery had skyrocketing funding costs.

Mario Draghi’s “Whatever It Takes” Moment
[25:27]

• Draghi’s pledge restored confidence, ending the acute crisis.
  • “If the central bank says stop… as a speculator, you back off because you can’t speculate against the central bank.” [26:23]
• Illustrated the unique power of central banks’ credibility and firepower.

Main Lessons from the Crisis
[28:03]

• Market discipline is unreliable and discontinuous ("all-or-nothing" investor behavior).
  • “Before the crisis, Greek bonds were trading five basis points over German bonds. When markets paid attention… it became a destructive, self-fulfilling spiral.” [29:12]
• The original EMU design was "woefully inadequate": no lender of last resort, no crisis plans.
• No-bailout clause wasn’t realistic; capital could flee, and contagion made strict separation impossible.
• ECB eventually had to assume a (reluctant) lender-of-last-resort role.

The Low Inflation Trap and Unconventional Monetary Policy

[32:19]

• Post-crisis, inflation was persistently below target (<2%); ECB exhausted traditional rates, hit the effective lower bound (ELB).

Unconventional Tools:

• Forward guidance (“lowering interest rates without lowering interest rates”)

• Targeted longer-term operations (TLTROs)

• Quantitative easing (QE) to compress term and credit premia

• "QE works well for market stabilization and recapitalization. When it comes to sustaining 1% to 2% inflation, QE’s effectiveness is more questionable.” [49:07]

QE and Diminishing Returns
[39:46]

• Effectiveness of monetary stimulus is not linear; at low rates, further easing delivers diminishing effects (“vertical IS curve”).
• Aggregate euro area fiscal stance was contractionary, as all countries consolidated at once—ironic consequences of decentralized, cautious fiscal policy.

Theory vs. Practice
[43:52]

• "The Euro area fiscal stance suffers from a lack of ownership... very few policymakers feel responsible for it."
• Monetary and fiscal policies worked at cross-purposes until the pandemic.

The High-Inflation Episode and Policy Response

[54:07]

• COVID and war in Ukraine created unprecedented dual negative demand and supply shocks.

• Initial consensus was to ‘look through’ supply-driven inflation, trusting it to be transitory; with hindsight, this was wrong—persistent supply bottlenecks and a second energy shock led to entrenched inflation.

• Policy lags complicate response: “Monetary policy is only effective with an 18- to 24-month lag, so if bottlenecks resolve sooner, a rate hike is too late.” [54:35]

Second-Round and Services Effects:

• Wage bargaining and cost passthrough amplified and perpetuated inflation.

Quick, Substantial Tightening—Mild Effects

• ECB moved rates rapidly from -0.5% to 4% in 14 months, earlier tightening anticipated by markets.

• Surprised by limited fallout:

  “I would have thought that something might break... but really nothing happened.” [61:26]
  “We disinflated basically in four years… I think that is a pretty decent track record.”

Key Success Factor: Credibility and Independence

• Credible, independent central banks keep expectations anchored, lowering the social cost of disinflation:

  “The real reason for central bank independence is that it significantly lowers the cost of disinflation.” [63:27]

Limitations of Models and Importance of Judgment

[65:29]

• During COVID and energy crises, ECB’s models failed; staff forecasts continued to show quick return to target.
• Shifted from projections to actual, underlying inflation trend analysis.

  “Any model can only be as good as the data and shocks that go into it… If you have a pandemic and a war, the model isn’t much help.” [65:52]

Notable Quotes & Memorable Moments

• On arriving at the ECB:

  "Who are you to dissent immediately at the first meeting?... but then only two weeks later... it was all crisis management." [03:36]

• On QE’s limits:

  "Still, the full postmortem of QE, I have not yet seen a fully convincing postmortem." [49:07]

• On market discipline:

  "Market discipline is a euphemism… if the quality of policy deteriorates, you pay higher borrowing costs... unfortunately, the crisis told us this is not the way." [29:07]

• On ECB’s crisis role:

  “The central bank is the only party in the economy that can print money. So if the central bank says stop… you back off.” [26:23]

• On economics education vs. real-world crises:

  “The things I learned in university were, of course, of little practical value when it came to conducting monetary policy in an incomplete monetary union.” [05:18]

• On monetary and fiscal policy:

  “If you have 19 or 20 countries all individually consolidating… The aggregation is a euro area fiscal stance which is hugely contractionary.” [41:47]

• On central bank credibility:

  "If a central bank is independent and seen to be credible... you get a much better anchoring of inflation expectations." [63:27]

Q&A Highlights

Expectations Management vs. Actual Balance Sheet Expansion

[58:26]

• Q: Did “whatever it takes” matter more via expectations or balance sheet action?
• Knot:

  “If you can make a credible pledge as a central bank that you’re willing to go in... in unlimited amounts, there will be nobody speculating against you. That was the brilliance… no euro had to be spent.” [60:16]

On International Monetary Diplomacy & Swap Lines

[59:56]

• Importance of central bank cooperation remains but less optimism about global coordination.
• QE’s effectiveness not directly tied to swap lines, though swap lines are crucial for systemic liquidity.

On De-globalization, Inflation, and Future Risks

[67:44]

• De-globalization will likely be inflationary as it raises structural costs.
• Central bank independence is more legally anchored in the EU than in the US, reducing potential risk from political interference.

On Long-term Euro Area Reform

[71:31]

• Is it sustainable for the ECB to provide European-wide safe assets, or should there be eurobonds?

• Knot:

  Decision is for elected officials, but many public goods are better supplied at the EU level and should be jointly financed, potentially by more common EU debt rather than only national contributions. [72:36]

• On more EU fiscal room post-crisis:

  Common EU finance for genuine EU public goods (like climate, security, transport) is rationale for EU-level debt, not for mutualizing prior national debts.

Timestamps for Important Segments

• Introduction & Overview: 00:16 – 03:00
• Eurozone Crisis: 03:00 – 32:19
• Lessons from the Crisis: 28:00 – 32:19
• Low Inflation and QE: 32:19 – 49:07
• QE Effectiveness & Side Effects: 49:07 – 54:07
• Pandemic/High Inflation: 54:07 – 63:27
• Models vs. Reality: 65:29 – 66:03
• Q&A Session: 57:23 – 75:49

Closing Thoughts

Knot’s retrospective underlines that monetary policy in practice operates far beyond textbook scenarios. The interaction of fiscal policy, institutional design, confidence, and expectations management is central. Above all, independence and credibility remain the ECB’s most potent tools—allowing it to learn, improvise, and sometimes, as in Draghi’s “whatever it takes,” turn words into decisive stabilizing action.

“It is crucial... that the central bank is actually independent and can be seen to take the measures needed to bring inflation back to target. If that is the case, it can do so at much lower economic and social cost.”
—Klaas Knot [71:03]