THE EUROPEAN CENTRAL BANK (ECB)

Since 1 January 1999 the European Central Bank (ECB) has been responsible for conducting monetary policy for the euro area – the world’s largest economy after the United States.

The euro area came into being when responsibility for monetary policy was transferred from the national central banks of 11 EU Member States to the ECB in January 1999. Greece joined as the 12th member two years later. The creation of the euro area and a new supranational institution, the ECB, was a milestone in a long and complex process of European integration.

The 12 countries had to fulfil the convergence criteria, as will other EU Member States prior to adopting the euro. The criteria set out the economic and legal preconditions for countries to participate successfully in Economic and Monetary Union.

The legal basis for the single monetary policy is the Treaty establishing the European Community and the Statute of the European System of Central Banks and of the European Central Bank. The Statute established both the ECB and the European System of Central Banks (ESCB) as from 1 June 1998.

The ECB was established as the core of the Euro system and the ESCB. The ECB and the national central banks together perform the tasks they have been entrusted with. The ECB has legal personality under public international law European System of Central Banks

The ESCB comprises the ECB and the national central banks (NCBs) of all EU Member States (Article 107.1 of the Treaty) whether they have adopted the euro or not.

Goals

The European Central Bank and the national central banks together constitute the Eurosystem, the central banking system of the euro area. The main objective of the Eurosystem is to maintain price stability: safeguarding the value of the euro.

The European Central Bank is responsible for the prudential supervision of credit institutions located in the euro area and participating non-euro area Member States, within the Single Supervisory Mechanism, which also comprises the national competent authorities.

Communication with Markets

• Speeches by governors both in their role as ECB governors, and in their roles as national central bank governors.
• Press conference following meeting at the start of the month
• No minutes or transcript of the meetings are published

Meeting Frequency

• Twice per month – once at the start and once in the middle of the month. The meeting at the beginning of the month is normally on the first Thursday.
• At its first meeting, as a rule, the Governing Council assesses the economic situation and the stance of the monetary policy. Decisions on the key interest rates are normally taken during that meeting.
• At its second meeting, the Governing Council focuses mainly on issues related to other tasks and responsibilities of the ECB.
• August is a ‘holiday’ of sorts – there is no press conference following either meeting, so no rate changes are likely in August
• Interest rate decisions are c. 1245 London time, press conferences are c. 1330 London time, and normally last c. 45m to 1h. There is an ‘introductory statement’, which provides a comprehensive summary of the assessment of economic developments and explains the monetary policy decision taken by the Governing Council.
• This is followed by a Q&A session, which provides a platform for the timely explanation of monetary policy decisions to the public.

Announcements

Monthly bulletins are published around the middle of each month. The editorial, a summary of ECB views, tends to get the immediate attention of the market.

ECB forecasts for growth and inflation are announced quarterly, at press conferences in Mar / Jun / Sep / Dec. Changes to staff forecasts can have a significant market impact.

Annual report on the ECB’s “activities and on the monetary policy of the previous and the current year”. The President of the ECB’s Governing Council testifies to the European Parliament on the annual report (quote from the ECB)

Reputation

Communication policy is, at times, muddled – likely a result of the relatively large number of people involved in setting rates, and the economic divergence between different countries in the Euro-zone.

As a rule of thumb, northern European (most notably Germany, France, the Netherlands) ECB members have been regarded as hawkish while southern European (Italy, Spain, Portugal, Greece) members have been regarded as dovish.

Remember: In the context of interest rates, a Hawk is predisposed to raising (or not cutting) rates, while a Dove is predisposed to cutting (or not raising) rates.

Structure of Decision-Making Body

The ECB’s Governing Council sets interest rates. This comprises the 12 governors of the central banks of the nation’s making up the Euro-zone, plus an “Executive Board” of 6 members, including the President and Vice-President.

The ECB is a “collegiate” body, which means there is no vote – decisions are made on a consensual basis (as a result, there are obviously no voting records, as there are with the Fed and BoE, which arguably makes it harder to identify hawks and doves).

Euro system

The Euro system comprises the ECB and the NCBs of those countries that have adopted the euro. The Euro system and the ESCB will co-exist as long as there are EU Member States outside the euro area.

Euro Area

The euro area consists of the EU countries that have adopted the euro.

Tasks

The tasks of the ESCB and of the Euro system are laid down in the Treaty establishing the European Community. They are specified in the Statute of the European System of Central Banks (ESCB) and of the European Central Bank (ECB). The Statute is a protocol attached to the Treaty.

The Treaty text refers to the ‘ESCB’ rather than to the ‘Euro system’. It was drawn up on the premise that eventually all EU Member States will adopt the euro. Until then, the Euro system will carry out the tasks.

Objectives

“The primary objective of the ESCB shall be to maintain price stability” AND “without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community as laid down in Article 2.” (Treaty article 105.1)

The objectives of the Union (Article 2 of the Treaty on European Union) are a high level of employment and sustainable and non-inflationary growth.

Basic Tasks

According to the Treaty establishing the European Community (Article 105.2), the basic tasks are:

• the definition and implementation of monetary policy for the euro area;
• the conduct of foreign exchange operations;
• the holding and management of the official foreign reserves of the euro area countries (portfolio management);
• the promotion of the smooth operation of payment systems.

Further Tasks

Banknotes – The ECB has the exclusive right to authorise the issuance of banknotes within the euro area

Statistics – In cooperation with the NCBs, the ECB collects statistical information necessary for fulfilling the tasks, either from national authorities or directly from economic agents

Financial stability & supervision – The Euro system contributes to the smooth conduct of policies pursued by the authorities in charge related to the prudential supervision of credit institutions and the stability of the financial system

International and European cooperation – The ECB maintains working relations with relevant institutions, bodies and for both within the EU and internationally in respect of tasks entrusted to the Euro system.

Political Independence

The independence of the ECB is conducive to maintaining price stability. Theoretical analysis and empirical evidence show this. The ECB’s independence is laid down in the institutional framework for the single monetary policy (in the Treaty and in the Statute).

Practical Implications

Neither the ECB nor the national central banks (NCBs), nor any member of their decision-making bodies, can seek or take instructions from European Community institutions or bodies, from any government of an EU Member State or from any other body. Community institutions and bodies and the governments of the Member States must respect this principle and not seek to influence the members of the decision-making bodies of the ECB (Article 108 of the Treaty).

Other Provisions

The ECB’s financial arrangements are kept separate from those of the European Community. The ECB has its own budget. Its capital is subscribed and paid up by the euro area NCBs. The Statute foresees long terms of office for the members of the Governing Council. Members of the Executive Board cannot be re-appointed. Governors of NCBs and members of the Executive Board have security of tenure:

• a minimum term of office for NCB governors of five years;
• a non-renewable term of office of eight years for members of the Executive Board of the ECB;
• removal of either from office only in the event of incapacity or serious misconduct;
• the Court of Justice of the European Communities is competent to settle any disputes.

The Euro system is prohibited from granting loans to Community bodies or national public-sector entities. This further shields it from any influence exercised by public authorities. The Euro system is functionally independent. The ECB has at its disposal all instruments and competencies necessary for the conduct of an efficient monetary policy and is authorised to decide autonomously how and when to use them.

The ECB has the right to adopt binding regulations to the extent necessary to carry out the tasks of the ESCB and in certain other cases as laid down in specific acts of the EU Council.

Transparency – Definition

Transparency means that the central bank provides the general public and the markets with all relevant information on its strategy, assessments and policy decisions as well as its procedures in an open, clear and timely manner. Today, most central banks, including the ECB, consider transparency as crucial. This is true especially for their monetary policy framework. The ECB gives a high priority to communicating effectively with the public.

Transparency of the ECB’s Monetary Policy

Transparency helps the public to understand the ECB’s monetary policy. Better public understanding makes the policy more credible and effective. Transparency means that the ECB explains how it interprets its mandate and that it is forthcoming about its policy goals.

Credibility

The ECB fosters credibility by being clear about its mandate and how it performs its tasks. When the ECB is perceived as being able and willing to achieve its policy mandate, price expectations are well anchored. Regular communication about a central bank’s assessment of the economic situation is particularly useful. It is also helpful for central banks to be open and realistic about what monetary policy can do and, even more importantly, what it cannot do.

Self-Discipline

A strong commitment to transparency imposes self-discipline on policymakers. It ensures that their policy decisions and explanations are consistent over time. Facilitating public scrutiny of monetary policy actions enhances the incentives for the decision-making bodies to fulfil their mandates in the best possible manner.

Predictability

The ECB publicly announces its monetary policy strategy and communicates its regular assessment of economic developments. This helps the markets to understand the systematic response pattern of monetary policy to economic developments and shocks. It makes policy moves more predictable for the markets over the medium term. Market expectations can thus be formed more efficiently and accurately.

If market agents can broadly anticipate policy responses, this allows a rapid implementation of changes in monetary policy into financial variables. This in turn can shorten the process by which monetary policy is transmitted into investment and consumption decisions. It can accelerate any necessary economic adjustments and potentially enhance the effectiveness of monetary policy.

Reporting Obligations

To retain legitimacy, an independent central bank must be accountable to democratic institutions and the general public for its actions in the pursuit of its mandate. The ECB has precise reporting obligations. These are laid down in Article 15 of its Statute. According to the Statute, the ECB is required to publish quarterly reports on the activities of the Euro system as well as a consolidated Weekly Financial Statement.

In addition, it must produce an Annual Report on its activities and on the monetary policy of the previous and the current year. The Annual Report has to be addressed to the European Parliament, the EU Council, the European Commission and the European Council.

To fulfil the requirements of the Statute, the ECB publishes:

• a Monthly Bulletin (in addition to a quarterly one)
• a consolidated Weekly Financial Statement
• Annual Reports

Besides that, the ECB produces a range of other task-related publications.

Objective of Monetary Policy

To maintain price stability is the primary objective of the Euro system and of the single monetary policy for which it is responsible. This is laid down in the Treaty establishing the European Community, Article 105 (1).

“Without prejudice to the objective of price stability”, the Euro system will also “support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community”. These include a “high level of employment” and “sustainable and non-inflationary growth”.

The Treaty establishes a clear hierarchy of objectives for the Euro system. It assigns overriding importance to price stability. The Treaty makes clear that ensuring price stability is the most important contribution that monetary policy can make to achieve a favourable economic environment and a high level of employment.

These Treaty provisions reflect the broad consensus that:

• the benefits of price stability are substantial. Maintaining stable prices on a sustained basis is a crucial pre-condition for increasing economic welfare and the growth potential of an economy.
• the natural role of monetary policy in the economy is to maintain price stability.

Monetary policy can affect real activity only in the shorter term (see the transmission mechanism). But ultimately it can only influence the price level in the economy. The Treaty provisions also imply that, in the actual implementation of monetary policy decisions aimed at maintaining price stability, the Euro system should also consider the broader economic goals of the Community. Given that monetary policy can affect real activity in the shorter term, the ECB typically should avoid generating excessive fluctuations in output and employment if this is in line with the pursuit of its primary objective.

Transmission Mechanism of Monetary Policy

This is the process through which monetary policy decisions affect the economy in general and the price level. The transmission mechanism is characterised by long, variable and uncertain time lags. Thus, it is difficult to predict the precise effect of monetary policy actions on the economy and price level. The chart below provides a schematic illustration of the main transmission channels of monetary policy decisions:

Change in official Interest Rates

The central bank provides funds to the banking system and charges interest. Given its monopoly power over the issuing of money, the central bank can fully determine this interest rate.

Affects Banks and Money-Market Interest Rates

The change in the official interest rates affects directly money-market interest rates and, indirectly, lending and deposit rates, which are set by banks to their customers.

Affects Expectations

Expectations of future official interest-rate changes affect medium and long-term interest rates. Longer-term interest rates depend in part on market expectations about the future course of short-term rates.

Monetary policy can also guide economic agents’ expectations of future inflation and thus influence price developments. A central bank with a high degree of credibility firmly anchors expectations of price stability. In this case, economic agents do not have to increase their prices for fear of higher inflation or reduce them for fear of deflation.

Affects Asset Prices

The impact on financing conditions in the economy and on market expectations triggered by monetary policy actions may lead to adjustments in asset prices (e.g. stock market prices) and the exchange rate. Changes in the exchange rate can affect inflation directly, insofar as imported goods are directly used in consumption, but they may also work through other channels.

Affects Saving and Investment Decisions

Changes in interest rates affect saving and investment decisions of households and firms. For example, everything else being equal, higher interest rates make it less attractive to take out loans for financing consumption or investment. In addition, consumption and investment are also affected by movements in asset prices via wealth effects and effects on the value of collateral. For example, as equity prices rise, share owning households become wealthier and may choose to increase their consumption.

Conversely, when equity prices fall, households may reduce consumption. Asset prices can also have impact on aggregate demand via the value of collateral that allows borrowers to get more loans and/or to reduce the risk premia demanded by lenders/banks.

Affects the Supply of Credit

For example, higher interest rates increase the risk of borrowers being unable to pay back their loans. Banks may cut back on the amount of funds they lend to households and firms. This may also reduce the consumption and investment by households and firms respectively.

Leads to changes in Aggregate Demand and Prices

Changes in consumption and investment will change the level of domestic demand for goods and services relative to domestic supply. When demand exceeds supply, upward price pressure is likely to occur. In addition, changes in aggregate demand may translate into tighter or looser conditions in labour and intermediate product markets. This in turn can affect price and wage-setting in the respective market.

Empirical evidence on the Monetary Policy Transmission in the Euro Area

Understanding the transmission mechanism is crucial for monetary policy. It is, therefore, not surprising that several studies – produced by both academics and Euro system staff – have tried to shed more light on the complex interactions underlying it. While still subject to considerable uncertainty (among other things related to the use of largely pre-1999 data), the main results of the studies on this issue seem to confirm that several widely accepted and well-established facts are also valid for the euro area:

Evidence on the channels of Monetary Policy Transmission in the Euro Area

Regarding the responses of individual components of GDP to interest rate changes, some studies stress the importance of the impact of monetary policy on investment compared with its impact on consumption and other components of aggregate demand. Business investment is mainly influenced by changes in the user cost of capital (a variable that is closely linked to interest rates).

It is also sensitive, albeit to a more limited extent, to liquidity or cash-flow constraints (i.e. the ability of firms to issue debt on financial markets or to borrow from banks). Available empirical studies also suggest that exchange rate effects can be quite important in the euro area. Hence, the response of consumer prices to a change in the official central bank interest rates will also depend on the effects of this change on the exchange rate. For example, the larger the appreciation of the euro triggered by a change in interest rates, the faster and larger the decline in inflation will be. However, the central bank can take for granted neither the size nor the direction of the exchange rate response to the interest rate because this response depends on other factors, e.g. foreign monetary policy developments, which are not controlled by the central bank.