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). In contrast to the Federal Reserve, ECB subordinates the objective of full employment to price stability.
The Governing Council of the European Central Bank stabilizes prices through monetary policy by setting 3 key interest rates:
- the main refinancing operations (MRO) rate that provides the most liquidity to the banking system;
- the Deposit Facility rate on overnight deposits by banks within the Eurosystem;
- the Marginal Lending Facility rate on overnight credit to banks from the Eurosystem.
Monetary Policy Objectives
The ECB has adopted several monetary policy guidelines:
- operational efficiency, to enable monetary policy decisions that change short-term money market rates quickly and precisely;
- equal treatment of financial institutions, regardless of their size or location within the euro area;
- decentralized implementation whereby the ECB coordinates the operations by the national central banks actually implementing the policy.
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:
- simplicity and transparency of monetary policy objectives to enable easy comprehension and implementation;
- implementing changes as small steps and observing the economic reaction of each step;
- minimizing risk to the financial institutions; and
- minimizing cost to both the central banks and their counterparties.
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:
- changing the refinancing rate to directly affect money market interest rates;
- setting expectations of future interest rates and inflation, which directly affects medium and long-term interest rates;
- changing saving and investment decisions of both households and firms, with higher rates increasing savings and investments while decreasing borrowing for consumption. Higher interest rates also increase the risk that borrowers will not be able to pay back their loans, thereby causing lenders to decrease the amount of available credit.
- Interest rates can also affect asset prices, since many assets are bought with borrowed money. Real estate is a prime example of an asset whose value varies with interest rates.
- Interest rates also affect aggregate demand and supply, which can have an effect on wages and prices in general.
- Low interest rates increase borrowing because of the increase in asset prices that are used as collateral, instilling greater confidence in the borrowers and the lenders, and because lenders are willing to take more risks to earn a higher yield. The result of keeping interest rates low for too long is what partly caused the 2008 credit crisis.
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 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
The ECB achieves its objective of price stability by restricting the interest rates in the interbank lending market to a narrow corridor, reflected in the Euro Overnight Index Average (EONIA), which is similar to the federal funds rate in the United States. 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.