European Central Bank Monetary Policy

The prime objective of the European Central Bank (ECB) is to maintain price stability over a medium-term, which the ECB's Governing Council defined as "a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%." The European Central Bank's monetary policy objectives have been set by the Treaty on the Functioning of the European Union, Article 127 (1).

The Governing Council of the European Central Bank stabilizes prices through monetary policy by setting 3 key interest rates:

Monetary Policy Objectives

Article continues below this space.

The ECB has adopted several monetary policy guidelines:

Monetary Policy Transmission Mechanism

The monetary policy transmission mechanism is the link that connects monetary policy to changes in the economy. The desired characteristics of any monetary policy transmission mechanism include:

Operating instruments are the actual policy tools that the central bank has direct control over. For instance, every bank controls its balance sheet, which can be used to expand or contract the monetary base or to control interest rates in the interbank lending market for reserves.

Historically, central bankers have used intermediate targets, such as the monetary aggregates, to achieve policy objectives. However, sometimes the link between the operating instruments and the intermediate targets or the intermediate targets and the final objectives is tenuous, yielding unpredictable results. Therefore, the ECB now focuses on the final objective, which is price stability.

The monetary policy transmission mechanism includes the steps that translate a change in monetary policy into a change in the economy, and includes the following:

A flowchart depicting the monetary policy transmission mechanism from target interest rates to changes in market prices. Economic shocks that affect prices, but which the central bank cannot control, include large changes in the global economy, bank capital, fiscal policy, and commodity prices.

Monetary Policy Operations

The ECB rarely buys securities outright. Reserves are provided to the European banking system primarily through what are called refinancing operations, which are weekly auctions of 2-week repurchase agreements in which the ECB, through the national central banks, provides reserves to banks in exchange for securities and then reverses the transactions 2 weeks later.

The ECB's Governing Council, which sets monetary policy for the ECB, establishes a main minimum interest rate in the refinancing options, called the minimum bid rate, which is equivalent to the target federal funds rate. Unlike in the United States, where monetary policy is conducted by the Federal Reserve Bank of New York, refinancing operations take place at the National Central Banks (NCBs). Any European financial institution that is subject to the ECB's reserve requirements may participate in the ECB's weekly auctions in contrast to the 20 primary security dealers that trade with the Fed in open market operations. The collateral that is required for refinancing operations differs in different countries, and can include government issued bonds, privately issued bonds, and bank loans. The types of collateral accepted were extended during the 2008 credit crisis to provide greater liquidity to the banking system. There are also long-term refinancing operations with 3-month terms; and infrequent, smaller, shorter duration operations when reserve levels have to be fine-tuned.

Deposit Facility and Marginal Lending Facility

Article continues below this space.

The ECB achieves its objective of price stability by restricting the interest rates in the interbank lending market to a narrow channel. To provide a corridor, or channel, for the overnight cash rate, which is the interbank lending market rate, the ECB provides 2 facilities to put a floor and a ceiling on the overnight cash rate.

The ECB provides the Deposit Facility where banks can place excess reserves and earn an interest rate that is usually 100 basis points, or 1%, below the main refinancing rate. This establishes the floor on the interest rate, since no bank will lend money out at less than what it can earn at the Deposit Facility.

Similar to the Federal Reserve's discount window, the Marginal Lending Facility makes overnight loans to banks who apply for it with an interest rate set by the Governing Council that is currently 100 basis points above the main refinancing rate. Banks will most often seek loans in the interbank lending market to supplement their reserves, where the interest rate is usually lower than the marginal lending facility rate and no collateral is needed. However, if a bank cannot borrow more cheaply in the marketplace, then it will borrow from the Marginal Lending Facility.

The Governing Council determines the interest rate spread between the main refinancing rate and both the marginal lending rate and the deposit facility rate. A corridor for interest rates in the interbank lending market is, thus, formed by the floor provided by the Deposit Facility and the ceiling established by the Marginal Lending Facility. This channel system helps to constrain the interest rate to within 1% of the main refinancing rate, thus establishing a corridor in which the interbank lending rate variation is limited to 2% between the lowest and highest rate.

The ECB also establishes minimum reserve requirements based on a bank's liabilities, which currently is 2% for checking accounts and other short-term deposits and debt securities with terms not greater than 2 years. Deposit levels are averaged over the previous month and are applied to the following month. The ECB pays interest on required reserves based on the interest rate from the weekly refinancing auctions, averaged over a month. The reserves are held at the National Central Bank of the country in which the financial institution is located.