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European Central Bank Monetary Policy: Literature Review Part 1

Evaluate the actions of the European Central Bank in the conduct of Monetary Policy, describing the main strategies and tools used to stabilise the Euro currency (Literature Review)

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Introduction

The European Central Bank (ECB) is the financial institution charged with the responsibility of administering the monetary policy within the Eurozone, made up of some 19 EU (European Union) member states (European Central Bank, 2017). The bank which has its headquarters in Frankfurt, Germany was established in 1998 courtesy of the Treaty of Amsterdam (European Central Bank, 2017). Article 2 of the ECB Statute enshrines the main objective of the central bank namely, to uphold price stability within the Eurozone (European Central Bank., n.d.). The Eurozone is an EMU (economic and monetary union) made up of 19 EU member states and has been in operation since 1999 (European Central Bank, 2012). According to Lastra (2009), the EMU is a common market of EU member states that have made a decision to not only share a common currency but also implement and adopt a single foreign exchange and monetary policy. Copeland and James (2014) are of the view that a common market aids in the conduction of duty-free trade, but there could be some capital, labour, and non-tariff barriers involved. For this reason, it may be necessary to allocate the factors of production between member states which have the potential to improve productivity. Moreover, reducing trade barriers among EU member states has been shown to favour an increase in the level of international trade that the members engage in.  The EC (2015) views the common market as the first step towards the creation of a single market, which acted as the goal of the Single European Act 1987. The Eurozone as a single geographical market is viewed as part of a single territory that permits the free movement of goods, services, people, and money without being hindered by trade barriers (Fabbrini, 2015). While arguing for the creation of a single market, the European Commission noted that its success was reliant on the use of a common currency among member states, a move that was also anticipated to bring about total transparency and the law of a single price for tradeable services and goods (Barnier, 2013). Having a common currency in the form of the euro among EU member states also means that the currency enjoys the same nominal value within the Eurozone.  Outside of the Eurozone, the ECB allows the euro to “float”. In other words, it does not intervene in the foreign exchange market aiming to appreciate or devalue the euro. The ECB administers the monetary policy of the euro.  The ECB endeavours to realise price stability through different tools of monetary policy. Monetary policy involves setting vital interest rates among member states that use the euro. They include the deposit rate; the refinancing rate; and the marginal lending rate. Further, the monetary policy entails such OMOs (open market operations) as LTROs (Longer-term refinancing operations) and, MROs (main refinancing operations). Other instruments that have also been added in recent years include QE (quantitative easing), SMP (securities markets programme) and OMT (outright monetary transactions).

ECB Monetary Policy Instruments  

The ECB offers banks deposit facilities and marginal lending facilities as two of its standing facilities. These facilities are intended to enable banks to either stall or acquire liquidity (Pattipeilohy et al., 2013).  Banks have to obtain these facilities which are characterised by an overnight maturity on their own initiative. According to Gilbert, Hessel and Verkaart (2013), banks use the deposit facility as an instrument for mopping up liquidity at rates which are considerably less than those in the market. On the other hand, Gilbert et al. (2013) note that through the marginal lending facility, banks have access to liquidity at rates that are considerably above the rates in the market. Since standing facilities are characterised by considerably lower interest rates on deposits and considerably higher interest rates on borrowings relative to the money market rates, the only time when banks make use of the standing facilities is if there are no other options. Since the only limitation on access to both of these facilities is the collateral requirements, they provide a floor and a ceiling for the interbank money market (Pattipeilohy et al., 2013).

According to Gilbert et al. (2013), the way in which the ECB impacts interest rates in the money market is by offering less or more liquidity to banks in case it seeks to increase or reduce interest rates. In this case, the ECB allocates to banks an amount of liquidity that enables them to meet their liquidity needs. Such liquidity should however reflect the ECB policy goals. The ECB relies on open market operations to move the short-term interest rates and manage liquidity. This involves the selling or purchase of financial assets. In case a bank buys assets, it increases its reserve at the central bank. Conversely, when the assets of a bank are sold, this reduces its reserves at the central bank.  Such operations are conducted by the NCBs (National Central Banks) in the EU.     

The key elements of the ECB monetary policy strategy were agreed upon by the ECB Governing Council on 13th October 1998. The Council identified three main elements: (i) a definition of price stability based on quantitative means; (ii) the use of a monetary aggregate to check on the money growth; and (iii) a diverse evaluation of price developments (Arestis and Sawyer, 2013). The European Central Bank (2011) notes that the implementation of its monetary policy hinges on two main pillars. In its first pillar, the ECB makes use of the monetary policy strategy with the goal of ascertaining the interest rate suitable for the realisation of price stability. According to the ECB (2011), this is known as a rate of inflation.  Article 105 of the Treaty of the EU (European Union) identifies price stability as one of the main roles of the ECB.  The treaty does not provide additional information regarding the final arrangement of the appropriate inflation rate in order to realise price stability. On account of this lack of clear definition, it appears as though the ECB defines price stability by exercising its discretion (Fitouussi and Saraceno, 2002). The ECB targets to achieve a price stability of “below, but close to, 2 per cent” (ECB, 2011), in the medium term. What this appears to suggest is that excessively low inflation along with inflation that falls above the 2 per cent threshold are not compatible with price stability. The ECB, in keeping with this target, further reported that its monetary policy would be guided by a reference value with reference to the money supply rate. Based on the observation that a short-term variation in the supply of money rarely leads to considerable impacts on the price level, this compelled the ECB to periodically consider the extensive M3 that is characterised by long-run stability attributes (Issing, 2002). In line with this, “the reference value for M3 is set at 4.5 per cent” (Issing, 2002, p. 86). A closer look at how the M3 developed in the Eurozone could perhaps explain the decision by the ECB In 2003 to cease undertaking an annual review of the reference value (Gaff, 2008). The projected target describes the year-on-year rise in the HICP (Harmonized Index of Consumer Prices). This is a harmonised target across all the countries in the Eurozone, and it is usually computed by Eurostat in collaboration with the statistical offices of respective national governments of EU member countries. The harmonisation of the target is done in such a manner as to closely match the actual price of consumer expenditure. The aim of the ECB monetary policy is to strongly secure inflation expectations according to a “consistent and systematic method for conducting monetary policy” (European Central Bank, 2011, p. 63). This is in turn anchored in a medium-term time frame, with the focus on open and clear communication to members of the public of the basic analysis and its goals. Nonetheless, although the inflation forecast acts as a key element of the policy discussion and analysis not just within the ECB governing bodies, but also in terms of public presentations, It is important to note that the ECB does not abide by a formal strategy of inflation targeting that involve quasi-automatic response to divergence in forecast inflation from the target within a predetermined time-frame. Instead, the actions taken by the ECB hinge on a largely flexible strategy in terms of the economic variables accounted for as well as the pertinent time frame for reacting to possible shocks in the economy. Accordingly, in evaluating the suitable reaction to a likely threat to price stability or a price shock, the nature and sources of the shock could involve various responses. For this reason, the ECB always endeavours to integrate financial stability with the other factors that need to be considered, on account of the potential implications of financial imbalances on price and output developments.  As such, although the ECB does not engage in formal targeting of monetary aggregates, the existence of a monetary pillar as part of the ECB’s strategy enables it to ‘lean against the wind’ of such mounting variances as unrestrained credit and money creation or increases in asset price (Micossi, 2015).

The operational framework constitutes the second pillar of the ECB’s monetary policy. This involves the various procedures and instruments that the ECB requires at its disposal in order to realise the projected interest rate. According to Article 18 of the ESCB Statute, in order for the ECB to undertake the tasks of the ESCB (European Systems of Central Banks), it can do one of two things. First, it can sell or buy outright, borrow or lend any of the various forms of market instruments, or even under repurchase agreements, using precious metals or any currency. Secondly, the ECB may liaise with various market participants especially credit institutions with the objective of undertaking credit operations, with lending being determined by the availability of sufficient collateral (Knupp, 2011).

Another requirement for the credit institutions within the Eurozone is that their current accounts at the Eurosystem must always have a certain minimum reserve. At the moment, the minimum reserves are maintained at 1% of debt securities and deposits, and they have a maturity period of up to two years. This particular requirement serves two purposes. First, it seeks to stabilise interest rates in the money market and secondly, to ensure that banks maintain a ‘structural’ liquidity scarcity as a means of strengthening the ability of the ECB to guide operations in the open market (European Central Bank, 2014).

The two pillars upon which the ECB monetary strategy hinges can be summarised as involving economic analysis and monetary analysis. The pillar of economic analysis evaluates medium and short-term determinants of price. The analysis is mainly concerned with financial conditions and real activity in the economy. According to Knupp (2011), the economic analysis considers that price developments on the financial conditions and real activity in the economy are for the most part, determined by the association between demand and supply in the services, goods, and factor markets. To achieve this economic analysis, the ECB undertakes regular reviews of the overall demand, output, labour market conditions, social policy, asset prices, cost and price indicators, as well as an assessment of BOPs (balance of payments) for the Eurozone (European Central Bank, 2011). On the other hand, the second pillar of monetary analysis is concerned with the long-run association between prices and money and actually acts as a tool for counter-checking the medium or short-term indicators of the monetary policy derived from the economic analysis. The strategy entails an in-depth assessment of credit and monetary developments which are intended to evaluate the implications for future economic growth and inflation (European Parliament, 2016).

Significance of interest rates

The ECB relies on interest rates as a strategy to realise its goal of price stability by means of an inflation rate set at nearly 2% of the interest rates. By capping interest rates at lower levels, consumers are encouraged to borrow more, in effect resulting in a rise in the money circulated by banks (Cancelo, Varela and  Sanchez-Santos, 2011). This development of events is attributed to the positive impact of reduced interest rates on inter-temporal consumption. Low-interest rates encourage consumption now because the future does not hold promising rewards for saving. Moreover, reduced interest rates are also associated with a positive impact on investment. Accordingly, reducing interest rates is a vital instrument of the ECB’s monetary policy. Consequently, an increase in consumer investment and spending leads to a rise in economic growth and by extension, a higher rate of inflation (Cancelo et al., 2011).

Conventional Instruments of the ECB’s Monetary Policy

The conventional instruments of monetary policy by all major central banks are to ensure control of their short-term nominal interest rates. In spite of changes in the definite arrangement of monetary policies, all leading central banks endeavour to set policy by means of targeting certain short-term interbank rates. Central banks frequently achieve this by setting a target rate, in addition to conducting suitable open market operations with a view to ensuring that interbank rates are in tune with the set target (Orphanides, 2014).

OMOs

MROs are among the main instruments that the ECB utilises to influence the banking systems’ short-term interest rates and to avail money to it (DNB, 2016).   However, the ECB only extends credit facilities to banks that are able to attach suitable assets as collateral (DNB, 2016).  This is a strategy aimed at reducing the risk of losses. Other OMOs come in the form of LTROs which take the form of a reverse transaction and so the ECB requires collateral from banks. According to DNB (2016), LTROs are carried out monthly and are characterised by a maturity period of three months. Over the past few years, the ECB added two single programs of LTROs with a maturity period of three years to its regular operations as a means of offsetting the euro crisis (Micossi, 2015). LTRO have an interest rate of nearly 1% (LTRO, 2016). Starting in June 2014, the ECB shifted its focus from the LTROs to the TLTROs. The new instruments were directed at banks in the EU that were ailing as a result of many liabilities.   The shift in focus was with a view to restoring the bank’s willingness to lead, given that there was a decline in investor funding, and while lending to the real economy had also declined significantly (DNB, 2016). In this case, the real economy refers to that part of the economy whose role it is to deal with the production and consumption of services and goods.  According to Knopers (2014), these TLTROs could have a maturity of up to 4 years and were hence touted as yet another source of cheap borrowing for banks considering that the interest rate was pegged on the refinancing rate predominant when the allotment was being done, in addition to a 10 basis point spread.

Marginal lending and deposit rate facility

Over and above the key refinancing rate, the ECB may also set both the marginal lending rate and the deposit rate. In this case, the deposit rate refers to the interest rate payable by banks in the Eurozone for depositing their money at the ECB. The ECB has set this at 0.40% annually, starting from 16th March 2016 (ECB, 2016).  The implication made is that banks are now required to pay the central bank for the surplus liquidity that it holds on their behalf. According to Randow and Kennedy (2016), this move is meant to discourage banks from parking too much liquidity at the central bank, thereby hindering the increased circulation of money into the real economy. The marginal lending rate is also available to banks that wish to receive credit quickly from their respective national banks after issuing collateral for the same. This particular instrument is intended to benefit banks that may require overnight credit that meets their liquidity requirements. The interest rate for the marginal lending facility is pegged at 0.01% or 100 basis points (DNB, n.d). This is obviously way above the minimum bid rate, or the lowest permissible interest rate limit.

Quantitative Easing (QE)

Quantitative easing has been successfully applied by both the Federal Reserve and the Bank of Japan and so it was just a matter of when, not if, the ECB would also adopt it. This eventually came to fruition on 9th March 2015 (Jones, 2015). However, the program, valued at a mouth-watering €1.1 trillion, was met with a lot of criticism and controversy when it was first announced. This notwithstanding, QE remains a vital tool for the ECB in terms of the achievement of their expansionary monetary policy. The policy was intended to reduce the long-term interest rate while also ensuring a rise in the supply of money to the economy. Some economists have described QE as the equivalent of injecting huge sums of “free” money into the economy. In this case, the term “free” hinges on the understanding that the ECB has to print electronic money that was not in existence previously.  The central banks print this “new” money with the aim of enabling them to purchase various assets for commercial banks. Some of the assets that the ECB seeks to purchase from commercial banks include corporate bonds, government bonds, and mortgage-backed securities (Saraceno and Tamborini, 2016). QE targets assets with a much higher maturity in comparison with the assets that open market operations target. As a result, this is likely to cause a drop in the yield of assets purchased by the ECB as their price increases. Banks then use the money received to purchase such new assets as bonds and shares, and this too causes a drop in the yield of these assets owing to their rising prices. For this reason, consumer interest rates also tend to be lower, a development that stimulates consumer investment and spending.

Saraceno and Tamborini (2016) note that the decision by the ECB to start the QE programme is a testament to the ongoing poor macroeconomic conditions that characterise certain countries in the Eurozone, along with a key transformation in the ECB’s monetary policy position with respect to the established Brussels-Berlin-Frankfurt consensus. In an attempt to justify the QE programme, the ECB has endeavoured to look at the growing gap between the expected and actual rate of inflation in the Eurozone below the official target of nearly 2% annually (Hartley, 20Draghai, 2014), even as traditional monetary tools have been largely ineffective owing to entrenched “nationalisation” and “segmentation” of financial markets (Saraceno and Tamborini, 2016). Similar sentiments have also been echoed by various authoritative academic scholars (for example, Orphanides, 2014; De Grauwe and Ji, 2015).  However, Demertzis and Wolff (2016) note that QE also impacts the prices of assets via the ‘portfolio balance’ channel. Banks reallocate the cash generated from the sale of assets to the central banks to other riskier assets as they pursue even higher profits. The immediate impact of QE on the profit margins of banks according to Montecino and Epstein (2014) is referred to as the ‘scarcity effect’.  Seeing as the securities with varying maturity periods act as imperfect substitutes, it follows then that the demand for long-term securities by the central bank is likely to result in the limited availability of such securities in the market, a move that is likely to trigger a rise in price, holding everything else constant. According to Demertzis and Wolff (2016), such an effect is likely due to the fact that the central bank is a large player in the market whose objective is to make use of QE as a tool for shifting bank incentives.  A study by Montecino and Epstein (2014) endeavoured to evaluate the profitability levels of banks in the US that sold their assets directly to the Federal Reserve Bank as part of the LSAP (Large-Scale Purchases) programme. The study findings revealed that the banks that sold their assets to the Fed realised a 0.35% rise in profitability in comparison with the other banks that did not participate in the LSAP. It is important to note that the figure reported is quite significant considering that the profitability of most banks is in the region of zero.

SMP and OMT

The ECB also introduced the SMP and OMT over and above QE. Eser and Schwaab (2013) report that SMP was made up of the ECB purchasing sovereign bonds in the secondary markets characterised by various debt issues which required liquidity.   The ECB soon replaced the SMP with the OMT. While the two instruments are nearly identical, a key difference is that OMT permits the purchase of sovereign bonds of specific countries in the Eurozone.  Moreover, the OMT establishes the ECB as a lender of last resort, especially during times of economic crisis. In such situations, EU member states would get assistance on condition that they are in agreement with the financial stability conditions established by the ESM/EFSF programme. Nonetheless, OMT does not translate into an increase in the money supply. This is because the ECB will invest a similar amount of money in the economy to the one that it takes out.

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