The European System of Central Bank (ESCB) is governed by European Central Bank (ECB) and the National Central Banks (NCB) of European Union Member States. European Central Bank is the Central Bank of Europe Zone. ESCB is governed by the governing council and other decision making bodies of ECB. The governing Council is responsible for making monetary decisions and the Executive Board is empowered to implement monetary policy as per the framework of decisions laid by the Governing Council. Just like any other Central Bank, the core function of ECB includes maintain price stability of the local currency in the form of Low Inflation and maintaining a corresponding level of money supply to do so. By doing this it safeguards the value of the currency of the economy. The bank has an independent Monetary Policy Committee that sets out the plans and policies for the Bank to implement Monetary Decisions. (Sawyer 2001)
However, in recent years, many central banks have shifted their emphasis of inflation policy. Instead of using the intermediary policy targets such as the money supply or the exchange rate to achieve price stability, emphasis has now moved towards the use of explicit inflation targets. (Griffith, 2011)
The monetary policy of European Central Bank is directed towards achieving the objective of providing a framework for non-inflationary growth in the economy. The bank follows two methods to control inflationary pressure in the economy.
Bank Rate: Interest rate at which Central bank of a country lends loans to Retail banks is called Bank Rates. Funds so obtained by retail banks are further injected in the form of commercial loans. Whenever, central bank cites inflation in the form of rise in price of consumer goods, it increases the interest rate at which it lends loans to the commercial bank. This increases the rate of commercial loans in the retail banks, an indirect measure to control money supply in the economy. Since interest rate determines cost of borrowing of the firms, it influences their long term as well as short term investment decision. Also, interest rates influences consumer spending on durable goods and household decision to purchase or sell the assets. Thus, with supply of money controlled through rise in interest rates, European Central Bank is able to bring down the nominal aggregate demand in the economy and thus inflationary pressure is controlled.
With nominal aggregate demand controlled and to the desired level, it becomes possible for the Bank to make the local currency powerful enough to run the economy and control the consumer goods prices.
Quantitative Easing: This policy of asset purchases is often known as 'Open Market Operations'. This policy is exercised by ECB to circumvent the banking system. Under this policy, bank in order to manage inflation around its target rate, creates leakages in the money supply by selling financial assets like bonds and shares to the private investors. Since, investors anticipates more return from ECB financial assets than holding the money, they invest their funds in purchasing the financial assets. This lowers long term borrowing cost and issuance of new securities in open market. As money of private investors is injected from the economy, it helps in lowering the nominal aggregate demand in the economy and thus keeps the inflation on track within the target rate. (Bank of England, 2013)
Types of open market operations:
Main refinancing operations: This provides a bulk of refinancing to the financial sector. These are the liquidity providing reverse transactions with a time frequency and maturity of one week. These refinancing operations are execute by National Central Bank on the basis of standard tenders and pre-determined calendar. This kind of open market operations is an important part of ECB open market operations. (European Central Bank, 2013)
Longer-term refinancing operations: These liquidity providing reverse transactions are conducted with monthly frequency and maturity of three months. These kind of market liquidity stimulators are conducted also conducted at irregular intervals, with maturity time ranging from six months, twelve months and till the length of one maintenance period. However, European Central Bank rarely conducts these kinds of open market operations. When ECB uses this instrument it conducts long term financing at fixed rate of interest, a situation where Euro zone does not act as a rate taker. With a view of not providing signals to the market, the Euro System acts a interest rate taker (with exception when ECB conducts long term financing) whenever it conducts these kind of open market operations. (European Central Bank, 2013)
Fine-tuning operations: These operations are aimed at steering of interest rates in the market and thus managing the liquidity position in the market. In particular, they are carried out with the objective to smooth the effects on interest rates caused by unexpected liquidity fluctuations. Just as other types of open market operations, these are also executed as reverse transactions, but may be executed in the form of foreign exchange swaps and term deposits. (European Central Bank, 2013)
Structural operations: These can be carried out by Euro system through reverse transactions, outright transactions and issuance of debt certificates. However, these kinds of open market operations can be executed when ECB wants to adjust the position of European Financial sector both on regular and non-regular basis. While, the Structural operations in the form of issuance of debt instruments and reverse transactions is carried out by National Central Bank (NCB) through standard tenders. However, outright transactions are transacted through bilateral procedures. (European Central Bank, 2013)
The Euro zone Crisis is an ongoing crisis in Euro zone affecting the economy since late 2009. The crisis was a result of sovereign Debt Risk, Banking Risk and Competitive Crisis. European Central Bank in order to bring down the price levels and to ensure currency stability changed its monetary policy.
In regard to budgetary deficit and declining GDP, European Central Bank eased their monetary policy by reducing bank rates significantly. This was designed to ensure better GDP Growth and employment levels.Also, non-standard measures, in the form of ECB’ enhanced credit support was introduced by the bank. These were introduced to ensure market functioning in order to bring the economy back from debt crisis. This proved instrumental in providing price stability as in the era of deteriorating economy, easing of interest rates and enhanced credit support ensured monetary policy stance.Also, the monetary policy strategy designed by ECB was foreseen with the objective of close monitoring of monetary developments and to develop asset price developments and prospective misalignments. Further, responding to monetary and credit dynamics as a part of assessment of risk to price stability propose that the interest rate decisions will tend to lean against asset price misalignments and financial imbalances. Many economists supported this new monetary policy framework with an idea that asset price distortion and financial crisis may be detected earlier by the central financial authorities, if, measures to stimulate the economy are taken considering new monetary policy framework. Thus they were of view that this monetary policy framework not only achieves price stability but also macro-economic and financial stability.(European Central Bank, 2012)
As announced by the Governing Council of European Central bank (ECB):
ECB will be an independent body and will takes the monetary and fiscal decision irrespective from any intervention from Government Bodies or any other group in society.
Majorly, ECB stopped using Quantitative Easing as the decisions taken in new policy framework to stance the monetary policy through easing of interest rates, seem appropriate to ECB.
ECB also launched “Security Markets Programme” to ensure proper functioning of the debt market. This was designed to eliminate asset price distortion from the financial market as this would help to stimulate the European Debt Securities Market.
In nutshell, ECB changed its monetary policy to ensure that its measures ensures by mitigating low liquidity and malfunctioning from the market and also it expanded the scope of central bank role as intermediary of transactions between banks, thus offering an alternative to private inter-bank money market. Thus, policy making considerations within the new monetary policy framework, aimed at eliminating asset price misalignments and financial distress from the economic system, will diminish the impact of financial crises on Euro Zone. (Mishkin, 2011)
Bank of England (2013), Quantitative Easing Explained, Available at: http://www.bankofengland.co.uk/monetarypolicy/Pages/qe/default.aspx (Accessed: 7th August 2013).
European Central Bank (2013) Open Market Operations, Available at: http://www.ecb.europa.eu/mopo/implement/intro/html/index.en.html (Accessed: 7th August 2013).
European Central Bank (2012), The Great Financial Crisis, Germany: European Central Bank
European Central Bank (2011), Implementation of Monetary Policy in The Euro Area, Germany: European Central Bank
European Central Bank (2013) The Euro system Instruments, Available at: http://www.ecb.europa.eu/mopo/implement/intro/html/index.en.html (Accessed: 7th August 2013).
Griffith, A and Wall, S (2011) Applied Economics, 10th edn., United Kingdom: Pearson
Mishkin, F (2011) Monetary Policy Strategy: Lessons from The Crisis, Cambridge: National Bureau of Economic Research.
Sawyer, M (2001) the UK Economy, 15th edn., United Kingdom: Oxford