Monetary policy of European Central Bank

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“Monetary policy of ECB”

european monetary liquidity

Glushchenko Diana

Finance 11804

Almaty 2014

There is a tendency to consider anything in human behavior that is unusual, not well known, or not well understood, as neurotic, psychopathic, immature, perverse, or the expression of some other sort of psychologic disturbance.

-- Alfred Charles Kinsey

Being unusual is not easy. Abnormal behaviour of people and large powerful institutions anchoring one's hope induces public to react, begrudge, admire and finally obey. During years ECB (The European Central Bank) has been implementing peculiar surprising monetary policy: in the midst of the financial and economic crisis the euro was in real danger of disappearing. The European Central Bank allocated loans to rescue EU banks; ECB lent them billions of euros- this fact became a sensation!

It was the fall of the Berlin Wall in 1989 that gave a boost to the creation of the European single currency and so to the ECB. In fact the bank is the successor of the European Monetary Institute which was created in 1993 under the treaty of Maastricht. Even though the very first euros came to circulation on the first 1^st of January 2002, ECB itself opened his doors in June 1998. Its first president was Wim Duisenberg; earlier he headed De Nederlandsche Bank. Between the 2003 and 2011 Jean-Claude Trichet was at the head of ECB. Its current president is Mario Draghi, he should remain at his post till 2019. Headquarters of ECB, - central bank of European Union and Eurozone, the biggest bank in Europe, possibly even the worlds, is situated in Frankfurt. It is a supranational institution and completely independent from member state control in terms of its mandate and day-to-day existence.

The operational modalities for OMTs (Outright Monetary Transactions) have been designed by the Governing Council, in full in dependence, from the perspective of what is necessary, proportional and effective for monetary policy purposes. The Governing Council will have full discretion in deciding on the start, continuation and suspension of OMTs in accordance with its monetary policy mandate.

[ECB Monthly Bulletin, Oct, 2012]

Nevertheless Mario Draghi should visit European Parliament meetings of economic and monetary policies and also present an annual report to Euro Parliament.

Today ECB is in charge of issuing the euro and managing the Eurozone's monetary policy. The bank is known for its transparency. It is crucial for monetary policy framework.

Transparency helps the public to understand the ECB's monetary policy. It 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. <https://www.ecb.europa.eu/ecb/orga/transparency/html/index.en.html>

But how it works? What is the mechanism of monetary policy? European Central Bank has its own rules and traditions called monetary policy decisions that include meetings procedure, key interest rates set by authorized body, non-standard measures applied during years, and future perspectives called forward guidance.

The Governing Council meets twice a month (Calendar). 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 and the Euro system.

<https://www.ecb.europa.eu/mopo/decisions/html/index.en.html>

Key interest rates for the euro area are set by ECB's Governing Council can be of three types: MROs (the interest rate on the main refinancing operations); the rate on the deposit facility; the rate on the marginal lending facility.

As an ECB's primary objective is the price stability, during financial crisis (2008, Sep), bank has introduced non-standard monetary policy measures.

Since the intensification of the financial crisis in September 2008, and against the background of rapidly receding inflationary pressures, the ECB has introduced monetary policy and liquidity management measures that are unprecedented in nature, scope and magnitude. At the onset of the financial crisis the ECB implemented forceful liquidity measures, with a view to protecting the flow of credit to the euro area economy and ensuring that the Governing Council's decisions concerning the stance of monetary policy were reflected in money and credit market conditions.

A key element in this context was the Governing Council's decision in October 2008 to increase the frequency and size of its longer-term refinancing operations (with a maturity of up to six months) and to conduct all liquidity-providing operations through a fixed rate tender procedure with full allotment. In addition, the ECB offered funding in US dollars and Swiss francs through foreign exchange swaps. Given that these changes to the ECB's operational framework are significant, they can be characterized as non-standard.

Overall, the above mentioned non-standard measures appear to have played a vital role in alleviating funding risk and providing financing support to the economy through banks. As a result, the past few months have witnessed a sizeable fall in term money market and loan interest rates, which have declined even faster than the key policy interest rate. Consequently, the ECB's monetary policy decisions and liquidity measures have been effective in averting a dramatic contraction in credit volumes. [ECB monthly bulletin, June, 2009]

The Wall Street Journal published an interesting article by Christopher Lawton called “ECB Considering Negative Deposit Rate” on the Feb, 12, 2014 that again proves that this bank sets absolutely surprising non-standard monetary policy measures.

The European Central Bank is "seriously" considering taking its rate on overnight bank deposits into negative territory.

"[Negative rates] is something we are considering very seriously," Benoоt Coeurй, ECB executive board member, told news agency Reuters in an interview, adding that it is "a very possible option."

The ECB confirmed Mr. Coeure's remarks.

Such a measure could help to kick-start the flow of bank credit to households and businesses by penalizing banks for parking their excess funds at the central bank instead of lending them to other banks in the financial markets.

<http://online.wsj.com/news/articles/SB10001424052702304888404579378720559631890>

But how do negative interest rates work in deposits? What does the bank make such decisions for? A negative interest rate is just another tax!

Negative interest on the Deposit Facility means that any bank holding funds in this type of account would pay (not earn) interest. Because banks can always move their funds out of the Deposit Facility into their Reserve Account they would easily avoid paying this `tax'.

Thus, to make the move somehow effective, the ECB would have to lower below zero the remuneration on any excess reserves, including any excess funds held on the Reserve Account. This way, banks would have no place to go: If they move their funds out of the Deposit Facility into the Reserve Account, they would still pay the `tax', graciously called a `negative interest rate'.

<http://www.creditwritedowns.com/2013/12/negative-interest-rates.html>

Forward guidance introduces results of 4^th July, 2013 meeting based on inflation fluctuations; Governing Council expects interest rates to stay at low level for the considerable period of time and price stability to maintain at the same level.

Analysis of current and ex-ECB's presidents' monetary policies can be effective because intertwines with theories applied before and can partially predict the future situation in a bank. As Mario Draghi takes charge, ECB monetary policy seems about to change. Jean-Claude Trichet, ex-president, kept interest rates high and may have served as a damper on struggling European economic growth. Draghi seems to following policies more like those of United States Federal Reserve chairman, Ben Bernanke. Interestingly both were doctoral students at a Massachusetts Institute of Technology. If, indeed, Draghi is going to follow Bernanke's lead in attempting to rescue the European economy, just what steps might he take?

Here we look at the so-called “Bernanke Doctrine”. Mr. Bernanke is considered an expert on the causes of the Great Depression and has written and spoken extensively about how to avoid deflation. His recipe for doing so is commonly referred to as the Bernanke Doctrine. Synopsis of this Doctrine could just be the roadmap for coming European Central Bank monetary policy: 1) Increase money supply; do this via printing money if necessary; 2) Maintain liquidity of the financial system; 3) Lower interest rates down to zero if necessary; 4) Control the yields on corporate bonds and other private securities; Lend money to banks a zero percent and take back corporate bonds as collateral; 5) Depreciate the US dollar; 6) Buy foreign currencies in large quantities; 7) Buy industries with printed money. That is, acquire equity stakes in banks and other financial institutions.

Will this be the shape of European Central Bank monetary policy in the months to come? The ECB already issued loans over $ 600 billion USD to ailing European banks at a 1% interest rate. Now there is a talk of lowering the base interest rate of the bank even more. Expected measures include lowering the interest rate to half a percent, directly purchasing government bonds, and printing money to inflate the bank balance sheet. The bank will be doing this in response to a generally faltering European economy. Individual European nations are taking on austerity measures in order to reduce their national debts. One effect of devaluating the euro will be to reduce these debts which are denominated in Euros.

An ECB monetary policy that mimics the Bernanke Doctrine will in all likelihood drive the Euro lower versus other major currencies. How far it drives the Euro down versus the US dollar may depend upon the degree and vigor to which the US Fed Reserve pursues the Bernanke Doctrine itself. It could be that a year or two from not both the US dollar and Euro will be substantially reduced in value versus Yen, British Pound, Canadian and Australian Dollars, Taiwanese dollars, and maintain Chinese Yuan. A long term effect of such would likely be stronger exports from both North America and Europe as their currencies would be more competitive. Of course, more competitive currencies could lead to both a stronger Euro and stronger Dollar. But, in the short run an ECB monetary policy that mimics that of US Fed Reserve and the Bernanke Doctrine could rescue the Europeans from their financial plight and drive the Euro downward in the process.

All non-standard measures adopted by bank seek to maintain price stability over the medium term and to ensure that inflation expectations remain firmly anchored in line with price stability. Price stability is seen as the big goal of the ECB. Maintaining prices of goods and services helps to prevent inflation. The ECB tries to maintain rates of inflation- close to or below 2%. Main objective of monetary policy is to make sure that 1 euro buys you as much as one year from now. It has been a rocky four years for the ECB; bank needed to rethink its monetary policy and manage the euro to help the members of the Eurozone.

Thomas Mann (German novelist, short story writer, social critic, philanthropist, essayist and 1929 Nobel laureate) said that `people's behavior makes sense if you think about it in terms of their goals, needs, and motives'.

References

Andrea Terzi, “What do negative interest rates do?” Credit Write-downs

http://www.creditwritedowns.com/2013/12/negative-interest-rates.html

Christopher Lawton, article “ECB Considering Negative Deposit Rate”, The Wall Street Journal, http://online.wsj.com/news/articles/SB10001424052702304888404579378720559631890

ECB official website, https://www.ecb.europa.eu/mopo/decisions/html/index.en.html

ECB monthly bulletin (June 2009, Oct 2012)

“European Central Bank Monetary Policy” video materials https://www.youtube.com/watch?v=CNEGmAymkNk

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