How is the monetary policy of the Eurosystem conducted?

What is the role of the Bank of Greece in the formulation of euro area monetary policy?

The Bank of Greece is a member of the Eurosystem, along with 18 other national central banks and the European Central Bank. It participates on an equal footing with the other national central banks in the formulation of the single monetary policy of the euro area, geared towards the primary objective of price stability, defined as annual inflation of below but close to 2% on average over the medium term. The Eurosystem thereby seeks to preserve the purchasing power of the euro and to make a meaningful contribution to sustainable economic growth and job creation. At the same time, as a supervisory authority, it ensures the smooth functioning of the financial system.

What are the tasks of the Governor of a Eurosystem national central bank?

The Governor of the Bank of Greece, together with the other Governors of the Eurosystem national central banks, participates in the Governing Council of the ECB with one vote, under a rotation scheme, in a personal and independent capacity. This means that governors do not represent their respective countries, but vote in full independence and with a view to the best interest of the euro area as a whole. The Governing Council is the main decision-making body for matters relating to the euro area monetary policy stance and implementation framework.

How do monetary policy decisions affect the economy?

By monetary policy decisions, a central bank aims to influence the cost and availability of money in an economy. Such decisions normally involve changes to the key interest rates, in particular the rate at which commercial banks are financed by the central bank. Any change to these rates affects in turn the money market rates and the bank deposit and lending rates for individuals and businesses. By this process, called the monetary policy transmission mechanism, monetary policy decisions affect developments in economic activity and prices.

 

During the first period of monetary union (1999-2007), when normal conditions prevailed, monetary policy transmission was very efficient. During the second period (from 2008 onwards), the Eurosystem was faced with unprecedented challenges amid significant turbulence both domestically and externally, which greatly complicated the Governing Council’s work in mitigating the impact on the euro area economy.

How has monetary policy been conducted so far?

Since monetary union was created, two distinct periods can be identified in the conduct of monetary policy:

During the first period, from 1999 to 2007, the macroeconomic environment in the euro area was characterised by stable economic developments, with small, mostly upward, movements in inflation. Whenever the Governing Council, based on its economic and monetary analysis, perceived a risk of inflation rising above its target in the medium term, it raised the ECB’s key interest rates (i.e. monetary policy tightening). Conversely, the Governing Council lowered the ECB’s key interest rates (i.e. monetary policy accommodation) whenever it perceived a risk of inflation falling below target.

As a result, market expectations regarding future inflation remained anchored, inflationary pressures were kept at bay and, despite significant upward price shocks, particularly in energy prices, inflation averaged almost 2.1% throughout this first period. Thus, during that time, the ECB’s conventional monetary policy through the interest rate tool played a decisive role in keeping inflation close to target.

The second period, from 2008 onwards, saw exceptional changes in the macroeconomic environment of the euro area. Initially, global financial markets experienced major turmoil and disruptions, and banks, in the euro area as well, faced severe liquidity constraints and high uncertainty. Subsequently, marked fiscal imbalances in certain euro area countries gave rise to market concerns about the sustainability of these countries’ public debt, triggering high volatility in the yields of their government securities. More recently, there has been a protracted decline in prices, leading to persistent very low, even negative, levels of actual and expected inflation, with adverse effects on the euro area economy.

Given that the inflation target is symmetric, in the sense that both upward and downward deviations of inflation from the ECB’s target are undesirable, the low levels of inflation had to be effectively addressed. Thus, the Governing Council made drastic cuts in the ECB’s key interest rates, bringing the main refinancing rate to zero and setting a negative interest rate on funds deposited by commercial banks with the central bank (deposit facility). However, the scope for further reducing the interest rates – which are close to their effective lower bound – was limited, as the monetary policy transmission mechanism was not working efficiently.

With a view to achieving price stability and restoring the smooth functioning of financial markets, the Governing Council adopted a number of additional unconventional (non-standard) monetary policy measures designed to complement the conventional monetary policy tools. The set of these measures succeeded in reinforcing the conventional interest rate policy, by providing sufficient monetary accommodation. This resulted in a reversal of the downward trend of prices, with average inflation standing around 1.4% in the second period.

Specifically, through the conduct of longer-term refinancing operations, in particular targeted longer-term refinancing operations (TLTROs), banks can obtain ample liquidity on very favourable terms; normal conditions are restored in financial markets; and bank lending to individuals and businesses is encouraged. In addition, the quantitative easing provided by the expanded asset purchase programme (APP) influences also medium-to-longer-term interest rates as well. Declines in these interest rates reduce the cost of bank borrowing for consumers and businesses, thereby boosting private sector spending. This, in turn, supports investment and consumption, bolstering economic growth and reducing downward deviations of inflation from target. Also important has been the contribution of forward guidance, indicating that monetary policy will remain accommodative and that key interest rates will be kept at their current levels, or even lower, for several months; this has helped to reduce uncertainty about future interest rates and to anchor the inflation expectations of markets.

Overall, since monetary union came into being, the Eurosystem’s monetary policy has successfully helped to support economic activity and maintain price stability.

The Governing Council of the ECB will continue to deal effectively with any challenges that may arise in future. Monetary policy instruments remain available, and there is adequate room for adjusting or enhancing them, if need be.

What is the review of the Eurosystem’s monetary policy strategy?

Recent experience and the new challenges that are emerging raise questions about the possible need for the Eurosystem to adapt its monetary policy strategy in light of the lessons learned and the dramatic changes of recent years. The monetary policy strategy comprises a quantitative definition of price stability and a two-pillar approach to the analysis of the risks to price stability. The Eurosystem’s monetary policy strategy was last reviewed in 2003. In late 2019, the Governing Council of the ECB decided to launch a debate in this regard, which could, in addition to monetary policy issues, also include issues such as climate change risks, the effects of monetary policy on income and wealth distribution, etc. The debate is planned to last until late 2020. Other major central banks, such as the US Federal Reserve and the Bank of Canada, are also currently revising their strategies.

For more details, see ECB President Christine Lagarde’s Press Conference on 12 December 2019.

 

The above presentation was created for educational purposes.
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