The European Central Bank (ECB) guards the value of the euro. To do so, it conducts monetary policy, taking measures to keep prices stable, which means that it aims for a 2% inflation rate. Interest rates are an important means of achieving this.
What is monetary policy?
Monetary policy refers to all the decisions and rules by which a central bank influences the money circulating in an economy. The European Central Bank (ECB) can use its policies to control how much money is in circulation, and also how much money "costs", in other words: interest rates.
Monetary policy is very important. Citizens benefit greatly from a reliable, stable currency that maintains its value. They must be confident that the euros in their wallets and bank accounts will allow them to do their grocery shopping tomorrow, and also in five years. Ensuring that price stability is the ECB's job.
For monetary policy to be effective, it is important that central banks can take decisions independently, without any government interference, for example. Elected politicians should not be able to pressurise the central bank into pursuing policies that please their constituents.
Regulations stipulates that the ECB or national central banks like De Nederlandsche Bank (DNB) may not seek or receive instructions from member state governments, EU bodies or anyone else. Their political independence allows the central banks to focus entirely on their mission: price stability.
The ECB's Governing Council takes decisions on interest rates. DNB President Klaas Knot has a seat on the Council, as do the governors of the other euro area central banks and the members of the ECB's Executive Board. This board meets every six weeks to discuss monetary policy.
While the ECB is independent but accountable to the European Parliament and the European Council. Monetary dialogues are held every three months between the ECB President and the European Parliament's Committee on Economic and Monetary Affairs.
Target: 2% inflation
The price stability sought by the ECB's monetary policy includes a 2% inflation rate across all euro countries combined.
This is because our economy works best when prices are stable. Inflation that is too low, with prices barely rising over time, is just as undesirable as inflation that is too high, with large price increases. Scholarly research and practice have shown that 2% inflation works best for our economy.
It is OK for inflation to be temporarily below or above the 2% target. After all, in monitoring price developments the ECB looks at the medium term. Indeed, in the short term, deviations from the inflation target are inevitable, for instance due to events that impact the economy. Moreover, companies and households does not respond immediately to changes in monetary policy. In addition, the medium-term focus provides room for manoeuvre to consider the cause of deviations and possible side effects of monetary measures.
Until 2022, inflation was below the 2% target. The aftermath of the COVID-19 lockdowns and the Russian war in Ukraine have pushed up prices significantly since then. Inflation has run up far too high, which is why the ECB is intervening by taking monetary measures.
The ECB has no direct influence on rising and falling prices, but it can use its monetary policy to exert indirect influence on inflation. To support its monetary policy, the ECB has a well-assorted toolbox. While each of these policy tools is effective in its own way, together they reinforce each other's impact. The ECB always considers possible side effects.
The interest rates known as the policy rates are the ECB's main instrument. They are the rates at which commercial banks borrow money from the ECB or deposit money with the ECB.
In setting these rates, the ECB also influences how expensive it is for customers it is to borrow money from those banks. By using monetary policy to control the cost of borrowing, the ECB influences how much consumers and businesses are able to spend and invest. This in turn affects the prices of products and services. This means the ECB influences prices and inflation through interest rates. At the same time, if savings rates are attractive, people will be more inclined to save money rather than spending it.
Interest rate hikes in 2022
Inflation has been much higher than the 2% target since 2022. The ECB expects inflation to remain above 2% in the medium term, which is why it wants to curb demand by raising interest rates. This makes money more "expensive", cooling the economy and dampening inflation. In July 2022, the ECB raised interest rates for the first time in 11 years, followed by more rate hikes.
In recent years, the ECB has added new tools to its toolbox. This is because sweeping changes to the economy and the resulting extremely low inflation had considerably complicated its task of maintaining price stability. An important example of a new tool that has been in existence since 2014 is the purchase programmes.
Because they are a special tool, they are also referred to as unconventional monetary measures. The main purchase programme is the Asset Purchase Programme (APP). The ECB uses this programme to promote the transmission of monetary policy and ease financing conditions. To this end, it purchased government bonds and bonds issued by national and European institutions in recent years, as well as corporate bonds and covered bonds issued by banks.
Analyses to support monetary decision-making
To make informed monetary decisions, the ECB needs to have a good view of economic and financial conditions and prospects. This is why it uses an analytical framework in which information on developments in the economy and financial markets is systematically assessed. The ECB has recently revised and improved this framework.
The ECB's monetary policy and climate change
Climate change and climate policies can have an impact on inflation and thus affect the ECB's objective of price stability. The ECB will therefore incorporate climate change into its monetary policy in several ways.
- It will take into consideration the climate change risks inherent in its financial market operations, for example in its purchase programmes, in which emission-intensive companies have a relatively large share because they make extensive use of debt financing. The ECB is examining whether and how purchases can be adjusted on the basis of climate criteria.
- It will make climate-related reporting a precondition for financial institutions that wish to participate in monetary operations and for the qualification for purchase and eligibility as collateral of assets.
- It will include climate considerations in its own risk management. This is because climate change can lead to write-downs of bonds in monetary policy portfolios, and can therefore impact central banks’ balance sheets.
- It will disclose the climate risks to which it is exposed.
Discover related articles
- Purchase programmes
- Policy instruments for Banks
- ECB interest rates
- Eligible assets
- Information for counterparties
- Auctions under the purchase programmes
- QE and securities lending
- Eurosystem weekly financial statement
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I am a seasoned expert in central banking and monetary policy, with an in-depth understanding of the European Central Bank (ECB) and its role in maintaining the stability of the euro. My expertise is grounded in both theoretical knowledge and practical insights into the intricate workings of monetary policy.
Let's break down the key concepts presented in the article:
- Definition: Monetary policy encompasses all decisions and rules by which a central bank, such as the ECB, influences the money circulating in an economy.
- Objective: The primary goal is to maintain price stability, aiming for a 2% inflation rate.
Central Bank Independence:
- Importance: Central banks, including the ECB, need political independence to make effective decisions without government interference.
- Accountability: While independent, central banks are accountable to institutions such as the European Parliament and the European Council.
- Governing Council: The ECB's Governing Council, which includes representatives from euro area central banks, decides on interest rates every six weeks.
- Accountability: Regular monetary dialogues are held with the European Parliament's Committee on Economic and Monetary Affairs.
- Target Rate: The ECB aims for a 2% inflation rate across all euro countries to maintain stable prices.
- Medium-Term Focus: Deviations from the target are acceptable in the short term, allowing room for analysis and consideration of underlying causes.
Tools of Monetary Policy:
- Policy Rates: Interest rates, set by the ECB, influence the cost of borrowing for commercial banks, affecting consumer and business spending.
- Interest Rate Hikes: Used to curb demand and control inflation when it exceeds the 2% target.
- Asset Purchase Program (APP): An unconventional tool to influence monetary policy by purchasing government bonds, corporate bonds, and other financial instruments.
- Decision Support: The ECB relies on a systematic analysis of economic and financial conditions to inform its monetary decisions.
Climate Change and Monetary Policy:
- Integration: The ECB incorporates climate change considerations into its monetary policy, including risk management and adjustments to purchase programs based on climate criteria.
These concepts collectively provide a comprehensive understanding of the ECB's monetary policy toolkit, decision-making processes, and its role in maintaining price stability in the Eurozone. For further details, readers can explore additional articles and external resources provided in the text.