6.1 How monetary policy works
In a market economy, the prices of individual goods and services must be free to move up and down in order to send undistorted signals regarding supply and demand conditions in the markets. In this way, the economy’s limited resources are directed to where they are needed and where they can be used most profitably. Price setting should be as free from government intervention as possible. For this reason, the central bank does not use its monetary policy to steer individual prices. Instead, it influences aggregate demand so as to have an indirect effect on the price level. The price level describes the average of all prices and – much like the prices of individual goods – is determined by supply and demand. It tends to rise if aggregate demand outpaces aggregate supply. In the opposite scenario, the price level declines.
Monetary policy influences the price level indirectly via aggregate demand.
Interest rates play an important role in aggregate demand: higher interest rates increase the incentive to save and make borrowing more expensive. If this results in less money being spent, this will tend to have a dampening effect on aggregate demand and thus on price developments. Conversely, lower interest rates tend to lead to rising (and also credit-financed) demand and consequently to higher prices.
Interest rates in the credit and capital markets therefore have an important signalling and steering function in that they represent prices for borrowing or remuneration for saving. However, they are not determined directly by the central bank. Traditional monetary policy instruments target banks’ funding conditions. These are the interest rates at which banks borrow central bank money from the central bank. Changes in these interest rates have an indirect impact on interest rates in the credit and capital markets and therefore also on aggregate demand.
Starting point for monetary policy: the need for central bank money
An important starting point for monetary policy is commercial banks’ need for central bank money – that is, the book money commercial banks hold on their accounts with the central bank as well as the currency in circulation. There are three reasons they require this funding: the demand for cash, the settlement of cashless payments via central bank accounts, and the requirement of maintaining a minimum reserve on their accounts with the central bank.
Bank customers request central bank money in the form of cash to use it to pay for their purchases. They generally receive cash from commercial banks – by withdrawing it from ATMs, for instance. Banks have to obtain the cash required for this purpose from the central bank. To do so, they must have cash paid out from the balance on their central bank account.
In addition, commercial banks require central bank money to settle cashless payments. Commercial banks usually settle payments via accounts held with the central bank. However, banks can effect transfers to one another only if they have a sufficient balance of funds on their central bank account.
Central banks may also require commercial banks to maintain a minimum reserve, meaning that a commercial bank must hold a minimum balance on its account with the central bank.
Only the central bank can create central bank money. This monopoly position is an important lever for monetary policy. The central bank usually lends to commercial banks to meet their need for central bank money. The lending central bank credits the loan amounts to the commercial banks in the form of deposits on their central bank accounts. The commercial banks have to pay interest on the loans. The level of this interest rate indirectly influences all other interest rates in the financial system. It is therefore called the “policy rate”.
The interest rate on central bank money is called the “policy rate”, as it affects all other interest rates.
Traditionally, central banks try to ensure monetary stability by adjusting their policy rates. However, the process by which a change in the policy rate is transmitted to a change in price developments takes time, is very complex and is thus not always easy to predict. This transmission mechanism depends, amongst other things, on how banks, households, enterprises and the government respond to policy rate changes.
The money market
Although every commercial bank needs central bank money, not all euro area commercial banks participate in central bank refinancing operations. Most leave this to the larger institutions, which subsequently lend the other banks a portion of the central bank money they receive.
The market where the supply and demand for these interbank loans in central bank money meet is called the market for central bank money, or simply “the money market”. Supply and demand in the money market are closely linked to cashless payments: commercial banks where cashless payments have resulted in an outflow of central bank money are able to cover their central bank money needs in the money market. “Overnight money” is traded most frequently in the money market, i.e. interbank loans (loans between commercial banks) with a maturity of one day only. However, alongside overnight money, interbank loans with maturities of one week, or one or several months, are also traded in the money market.
Up until the onset of the financial crisis in the summer of 2007, commercial banks had mostly granted unsecured loans in the money market, meaning that they did not demand any special loan collateral from their borrowers. However, once there were suddenly fears that banks could become insolvent overnight, this form of loan trading temporarily dried up. Lending between commercial banks has since recovered. Approximately one-quarter of these loans are now again granted without being backed by collateral, and around three-quarters are issued on a collateralised basis.
The transmission mechanism
This simplified depiction of the transmission mechanism illustrates how a change in the policy rate can affect price developments and thus the rate of inflation.
The starting point of the monetary policy chain presented here – the “interest rate channel”, as it is called – is the interest rate (i.e. the price) set by the central bank at which banks can borrow money from the central bank. If this policy rate rises, money market rates in the interbank market (money market) usually increase as well. The interbank market is where central bank money is traded between commercial banks in the form of account balances held with the central bank. Banks typically pass on the higher price of central bank money to their customers by raising their interest rates on corporate and personal loans. Demand for such loans generally declines when these bank loans become more expensive. As a result, credit-financed demand for goods and services in the economy weakens. In such an environment, enterprises have less scope to push through price increases to compensate for their heightened costs. Consequently, aggregate inflation is dampened and the inflation rate declines.
The monetary policy transmission process begins with a change in the policy rate.
The opposite is true when interest rates decline. It is cheaper for enterprises and households to take out bank loans, which in turn stimulates enterprises’ credit-financed investment activity and, at the same time, boosts consumers’ demand for durable consumer goods. Aggregate demand rises. Enterprises can increase their prices both more easily and by a greater amount. The rate of inflation tends to rise.
Impact on capital market rates
In the capital market, large enterprises and government bodies obtain long-term financial resources by selling bonds (also known as debt securities) and thus taking out loans. Bonds are securities with fixed maturities. The issuer pays (usually) fixed interest to the holder of the bond on an annual basis and the issuer buys back (redeems) the bond upon maturity. Bonds are traded daily on stock exchanges.
Capital market interest rates do not necessarily follow the change in the policy rate.
The relationship between the central bank’s policy rate and long-term capital market rates, i.e. interest rates in the bond market, is not as close as the relationship between the policy rate and short-term money market rates. If the central bank lowers its policy rate, long-term capital market rates do not necessarily fall to the same extent. For example, if investors fear that the cut in the policy rate will lead to higher inflation, they may even demand higher capital market rates to offset the loss they expect inflation to cause to the purchasing power of their long-term investments. When deciding on which monetary policy instrument to use and to what degree, the central bank must also always take into account the impact of its measures on the credibility of its stability-oriented stance. If the central bank jeopardises its credibility, it puts the success of its monetary policy measures at risk.
Exchange rate effects
Another important transmission channel of monetary policy is the exchange rate channel. The exchange rate is the price of one currency expressed in units of another currency. This also reacts to changes in monetary policy. For instance, if domestic interest rates outpace foreign interest rates, investment in the domestic capital market tends to become more attractive – for both domestic and foreign investors. This leads to higher demand for domestic currency, which makes the domestic currency more expensive relative to the foreign currency, provided that the exchange rate is not fixed by the government. The process is reversed if domestic interest rates fall compared with foreign interest rates.
Exchange rate fluctuations also affect demand and thus price developments.
Exchange rate changes like these have an impact on aggregate demand and on developments in the price level. If, for example, the euro gains in value against another currency (appreciation of the euro), products from this currency area become cheaper for buyers in the euro area. This also indirectly lowers the prices of goods produced in the euro area. At the same time, foreign consumers have to pay more for euro area goods priced in foreign currency. Demand for such goods therefore tends to decline. This further dampens inflation in the euro area as enterprises will try to make their products more attractive by lowering prices. The opposite is true if the euro loses value against another currency (depreciation of the euro). From a euro area perspective, imports of foreign goods become more expensive, whilst euro area exports become cheaper abroad, thus improving the sales opportunities for exports. The result is that domestic prices, and hence the inflation rate, also tend to increase.
The impact of monetary policy is not always easy to predict
The monetary policy transmission process is complex. There are multiple transmission mechanisms that can influence one another in a variety of ways. In addition, the behaviour of enterprises, consumers, banks and governments is subject to constant change. Some of these processes are fast: for example, financial markets usually respond immediately to changes in the policy rate. However, it often takes banks a while to pass on a policy rate cut to their customers in the form of lower lending rates.
Furthermore, the speed at which aggregate demand and prices change depends not only on the change in the policy rate but also on many other factors, such as developments in the global economy and the intensity of competition.
A central bank must always bear in mind the long and variable time lags before monetary policy takes effect and act in the most forward-looking manner possible. For the Eurosystem, in particular, this poses great demands on the analytical capacity of monetary policy, as the individual euro area countries have different financing practices, business cycles and economic structures.
Inflation expectations
The public’s inflation expectations are of particular significance from a monetary policy perspective. For example, if people expect inflation to increase due to a rise in commodity prices, trade unions will typically try to achieve higher wages to counteract the expected loss in purchasing power. As a consequence, enterprises will attempt to pass through the higher wage costs to the prices of their goods and services. In the worst-case scenario, a price-wage spiral can emerge, in which prices and wages drive each other up. If this causes a permanent and significant rise in inflation, the objective of price stability is jeopardised.
The expected level of inflation therefore has a considerable impact on the actual level of inflation. Monetary policymakers must therefore employ convincing stability policy and transparent communication to instil confidence that money will maintain its value. Anchoring inflation expectations in line with the objective of price stability is key here. If this is successful, the general public will perceive monetary policy as being convincing and reliable. In particular, longer-term inflation expectations thus always also serve as a barometer for central bank credibility.
Inflation expectations also affect the level of nominal interest rates. These rates are mainly determined by the expected real return on investment – the real interest rate – and the expected loss in the purchasing power of the investment amount over the investment period. The higher the expected inflation rate, the greater the financial compensation that potential debtors must pay their creditors for them to temporarily invest their money and not spend it themselves. Nominal interest rates are thus largely calculated as the sum of real interest rates and the expected inflation rate.
6.2 The monetary policy strategy
In order to achieve its primary objective of maintaining price stability over the medium term, the ECB Governing Council follows a “monetary policy strategy”. This strategy fulfils a dual role. First, it serves as an internal analytical framework for the Governing Council, which ensures that no relevant information is neglected in the pursuit of monetary stability. The Governing Council subsequently makes its monetary policy decisions on the basis of the findings obtained in this way. Second, the strategy also provides the framework for explaining monetary policy decisions clearly and comprehensibly to the general public.
The first element of the monetary policy strategy involves determining how the Governing Council defines price stability. It considers prices in the euro area to be stable if the year-on-year increase in the Harmonised Index of Consumer Prices (HICP) is below 2% over the medium term. In the pursuit of price stability, the Governing Council’s monetary policy measures are specifically geared towards keeping the inflation rate below, but close to, 2% over the medium term.
The second element concerns the comprehensive and systematic analysis of factors that can generate risks for price stability. Given that a large number of factors influence price developments, this analysis must ensure that no key factors are disregarded. This analysis is correspondingly broad, with a distinction being made between the first-round and second-round effects of price changes.
The Eurosystem’s two-pillar strategy
The second element of the Governing Council’s monetary policy strategy is based on two complementary approaches for making monetary policy decisions. In the “economic analysis”, the Eurosystem forms a comprehensive picture of the short-term and medium-term inflation outlook on the basis of a wide range of macroeconomic and financial indicators.
The ECB Governing Council bases its monetary policy on two complementary analytical approaches.
The “monetary analysis” focuses on developments in the money supply and lending. This two-pronged approach used to analyse risks to price stability is called the Eurosystem’s “two-pillar strategy”.
Pillar 1: Economic analysis
Factors that could endanger price stability in the near future include, for example, economic developments (demand pressure), the domestic cost situation (wages and wage negotiations) and the external situation (exchange rates and commodity prices). Moreover, financial market prices and corresponding surveys provide indications of business inflation expectations. Economic analysis therefore leads to a sound assessment of the short-term to medium-term outlook for inflation.
The economic analysis focuses on risks to price stability in the foreseeable future.
The Eurosystem’s macroeconomic projections play an important role in the economic analysis. They provide a comprehensive picture of current and prospective economic developments. These projections are produced jointly by experts from the ECB and the national central banks twice a year and are published in June and December. The projections are updated by ECB staff in March and September every year.
The projections centre on forecasts of macroeconomic performance (gross domestic product) and consumer price movements (as measured by the Harmonised Index of Consumer Prices). The term “projection” indicates that this is the result of a scenario based on a number of assumptions – for example, regarding oil prices or exchange rate developments.
First-round and second-round effects
In monetary policy analysis, a distinction is generally made between first-round and second-round effects. First-round effects show the impact of changes in the prices of individual goods or services on general price developments. Take a rise in crude oil prices, for example: the result is a direct increase in the prices of many oil products, such as petrol (direct first-round effect). However, this increase in crude oil prices also leads to higher prices for other goods and services for which oil products represent an important cost factor, such as air travel (indirect first-round effect).
Nevertheless, it is by no means certain to what extent and for how long a rise in crude oil prices will affect downstream prices. First, this depends on factors such as the country’s economic situation as well as the market power of the enterprises concerned, i.e. how easily enterprises are able to pass through higher costs to consumers by raising prices. Second, consumers’ responses to price increases also play a role. It depends on whether consumers cut back their consumption of products and services that now cost more or replace the more expensive goods with other, cheaper ones, or whether they do not change their consumption habits and reduce their savings or accumulate debt to finance the increased expenditure.
Monetary policymakers are not usually in a position to influence the original first-round price change or the ensuing effects on the inflation rate. Many central banks therefore take the approach of “looking through” these first-round effects. In other words, they focus on the general price trend instead. The fact that first-round effects have only a temporary impact on the inflation rate is also relevant in this context. This is because a one-off price change can no longer be measured in the inflation rate after one year, as this rate measures the price change over a twelve-month period.
However, monetary policymakers seek to prevent a situation in which first-round price changes give way to subsequent second-round effects that can lead to a sustained increase in the rate of inflation. Second-round effects represent market participants’ reactions to the first-round price increase that are undesirable from a monetary policy perspective. The focus here is on the reaction of the people who set wages. If, for example, trade unions strive to offset the loss in their members’ purchasing power resulting from higher crude oil prices by substantially raising wages, and thus return their purchasing power back to its original level, there is the danger of a price-wage spiral emerging. In such a case, rising prices and wages would drive each other up, potentially resulting in further accelerating inflation. In situations like this, there is also a risk that inflation expectations will decouple from the central bank’s target value and continue to rise.
Pillar 2: Monetary analysis
Past experience shows that inflation can persist in the long term only if the rise in prices is “financed” by a corresponding increase in the money supply. The Eurosystem therefore also monitors the relationship between the supply of money and price developments. However, the money-price relationship is not a fixed statistical relationship. Monetary developments can be influenced, particularly in the short term, by factors that impair their usefulness and informative value as an indicator of future price developments.
Monetary analysis monitors the relationship between money and price developments.
For this reason, monetary analysis has been expanded and refined over the last few years. Its main focus today is on analysing the transmission of monetary policy impulses through the banking sector. The Eurosystem therefore examines developments in the various components of the money supply and, at the same time, also carries out in-depth studies of the reasons for monetary growth. For example, analysing credit developments provides information on whether a change in interest rates even reaches households and enterprises via banks, as there may be scenarios in which banks do not pass on policy rate cuts to their customers. If this is the case, the policy rate cuts would probably have no impact at all on households’ and enterprises’ spending behaviour.
The results of the economic and monetary analysis are checked against each other.
The longer-run monetary analysis thus helps the ECB Governing Council to cross-check the results of the short-term to medium-term economic analysis. This cross-checking reduces the risk of monetary policymakers overlooking relevant information for the assessment of future inflationary risks.
6.3 Monetary policy instruments
Monetary policy decisions are made by the ECB Governing Council. The national central banks (NCBs) are responsible for the operational implementation of monetary policy, meaning that, in Germany, responsibility lies with the Deutsche Bundesbank. Commercial banks maintain the central bank accounts on which they hold their minimum reserves with their respective NCB. Monetary policy refinancing operations (open market operations) and collateral management are also carried out by the NCBs. In this way, the operational experience of the NCBs, as well as the technical and organisational infrastructure that they have in place, can be put to optimal use. The ECB may settle money market transactions directly with selected counterparties in exceptional cases only.
The use of monetary policy instruments by the Eurosystem and the nature of money market management have changed significantly since the onset of the financial crisis. While commercial banks’ need for central bank money was met primarily through short-term main refinancing operations before the crisis, the focus of monetary policy operations is now mainly on longer-term refinancing operations and on the Eurosystem’s ongoing asset purchases. A very sharp expansion of the stock of central bank money meant that banks’ structural needs for such funds turned into an exceptionally high surplus of central bank money in the banking system (liquidity surplus). Central bank money, which was previously scarce, is now available in abundance.
6.3.1 The minimum reserve requirement
The minimum reserve requirement is part of the Eurosystem’s monetary policy framework. In order to meet this requirement, commercial banks must hold a minimum deposit on their central bank account. This means that banks have a stable need for central bank money. The ECB Governing Council can use the minimum reserve amount required to influence commercial banks’ need for central bank money.
Banks are required to hold minimum balances with the central bank.
Calculating the minimum reserve
The minimum reserve amount required is calculated from the bank’s liabilities.
The minimum reserve amount required is calculated from a commercial bank’s liabilities subject to reserve requirements, measured at the end of selected months. For instance, overnight deposits, time deposits and savings deposits are subject to reserve requirements, but also debt securities issued by banks with an agreed maturity of up to two years as well as money market paper. These liabilities subject to reserve requirements are multiplied by the reserve ratio. The commercial bank must hold the resulting amount as a deposit with the central bank. The reserve maintenance period always begins on the Wednesday following the ECB Governing Council’s monetary policy meeting and – depending on the day of the week the meeting takes place – has typically lasted 42 or 49 days since 2015. Since January 2012, the reserve ratio has been 1%.
The minimum reserve’s buffer function
Banks do not have to maintain the required minimum reserve as a deposit on their central bank account in full every day, but rather only on average over the entire reserve maintenance period. This gives banks flexibility as the reserve balance can act as a buffer: if, for example, customer payment transactions mean that a bank sees an outflow of central bank money on a certain day, this reduces their existing deposit of central bank money and thus also the amount credited for the minimum reserve. The bank is then free to increase its deposit by borrowing in the money market on the same day or to wait to see whether it receives inflows of central bank money over the next few days.
The minimum reserve does not have to be maintained in full at all times, but only on average.
As banks have the option of fulfilling the minimum reserve requirement only on average over the reserve maintenance period, they do not need to be constantly active in the money market. This, in turn, helps to stabilise money market rates, as it means that they do not fluctuate permanently in line with demand. However, each commercial bank must ensure that it has met the minimum reserve requirement on average on the last day of the maintenance period.
Commercial banks’ balances held as minimum reserves on accounts with the national central banks are remunerated at the average interest rate on the main refinancing operations. As a result, commercial banks are essentially at no disadvantage in terms of interest rates or competitiveness due to the minimum reserve requirement as compared to banks outside the euro area, if these banks are not required to hold minimum reserves. If a bank’s balance on its central bank account exceeds its minimum reserve requirement on average over the reserve maintenance period, this “excess balance” is not remunerated. Since June 2014, a negative interest rate has been calculated for excess balances, which is exactly the same as the negative interest rate on the deposit facility. This gives banks an incentive to lend excess central bank money to other banks in the money market so as to boost lending to the economy.
6.3.2 Open market operations
The Eurosystem uses open market operations to provide central bank money to the banking sector. In particular, it grants loans to commercial banks against collateral. In times of monetary policy normality, the Eurosystem’s monetary policy operations centre around these operations.
In normal times, open market operations are at the heart of monetary policy operations.
If the central bank issues a loan to a commercial bank or purchases its securities, it credits the commercial bank with the corresponding amount in the form of a transferable deposit on its central bank account. Central bank money is created, which the commercial bank can use. If the commercial bank repays the loan or purchases securities from the central bank, the commercial bank’s transferable deposit with the central bank is reduced by the corresponding amount. Thus, the central bank money that was previously created ceases to exist again.
The central bank may purchase securities outright (outright transactions) or for a specific period only (reverse transactions). In the case of reverse securities transactions, the central bank purchases securities from commercial banks, but these banks must commit to repurchasing the securities after a certain period of time (e.g. after one week). Such open market transactions are called “repurchase agreements”, or “repos” for short. These short-term operations make it easier for the Eurosystem to change the volume of central bank money provided and the corresponding interest rate at short notice. In contrast to outright purchases and sales, repos have no direct impact on prices in the securities markets.
Main refinancing operations
The interest rate for main refinancing operations is the most important key interest rate.
Under normal circumstances, the Eurosystem’s main tool for providing central bank money is short-dated reverse transactions. These main refinancing operations have a maturity of seven days. When deciding the allotment for new operations, the Eurosystem can take into account a change in commercial banks’ need for central bank money – for example, because the economy needs more cash as a result of Christmas shopping. The interest rate for the main refinancing operations is the Eurosystem’s most important key interest rate. If the ECB Governing Council raises this policy rate, this is often referred to as a “tightening” of monetary policy; a cut in the policy rate is referred to as “loosening” of monetary policy.
Longer-term refinancing operations
The Eurosystem uses longer-term refinancing operations to provide banks with central bank money for one month or longer. In response to the financial crisis, the Eurosystem significantly expanded the share of longer-term central bank money for the first time, as banks were no longer granting unsecured loans to each other. The longer-term refinancing operations provided the banking system with sufficient central bank money. The maturities of these operations were extended first to six and twelve months and finally to up to three years.
In order to increase bank lending to the private sector and improve the functioning of the transmission mechanism, the ECB Governing Council conducted several targeted longer-term refinancing operations (TLTROs) with maturities of four years between the autumn of 2014 and the spring of 2017. These were followed by further TLTROs with maturities of two years starting in September 2019 and ending in March 2021. The basic idea is that the more loans commercial banks grant to the non-financial sector, the more favourable the interest rate terms of the TLTROs become. In this context, the interest rate on TLTRO loans can even be negative.
Fine-tuning operations
Fine-tuning operations smooth the effects on interest rates caused by unexpected fluctuations in the need for central bank money.
The Eurosystem conducts fine-tuning operations on an ad hoc basis to smooth the effects on interest rates caused by unexpected fluctuations in the need for central bank money. Fine-tuning operations can be used to provide or absorb central bank money. For example, the Eurosystem can grant very short-term credit to provide central bank money and offer to collect time deposits from commercial banks to absorb it. Foreign exchange swaps are another type of fine-tuning operation. The Eurosystem purchases foreign currency from banks against transferable deposits held with the central bank for a short period of time, thereby providing banks with central bank money. At the end of the swap’s term, banks have to buy the foreign currency back from the Eurosystem, with the amount payable being debited from their transferable deposits. The Eurosystem can also sell foreign currency from its own holdings for a limited period of time in order to temporarily absorb central bank money.
Structural operations
The aim of structural operations is to influence banks’ need for central bank money over the long term.
Structural operations are intended to influence commercial banks’ need for central bank money over the long term. If particular developments mean that the need for central bank money is so low that banks have little reliance on refinancing operations, standard monetary policy instruments will no longer take effect as they normally would. One way in which the Eurosystem could remedy this situation is by issuing certificates for its own debt to commercial banks: banks are required to pay the purchase price in central bank money, which permanently absorbs central bank money so that commercial banks are once again more dependent on the Eurosystem’s refinancing operations to cover their needs.
Procedures for tender operations
The Eurosystem executes its open market operations on the basis of either tenders or bilateral procedures. As a general rule, the Eurosystem uses tenders, and they take several forms.
Tenders are used to “auction” central bank money.
In variable rate tenders with minimum bid rates, the Eurosystem specifies in advance the total operation volume to be allotted and the minimum interest rate at which commercial banks must place their bids in order to be taken into consideration in the auction. Commercial banks then submit their bids in a sealed bid procedure, meaning that no bidder knows how much the other auction participants have bid. Each bank states the amount of money it wants to transact with the central bank and the interest rate at which it wants to enter into the transaction. The Eurosystem examines all of the bids and then lists them in descending order, i.e. the banks offering the highest interest rates are considered first, and then bids with successively lower interest rates are accepted until the Eurosystem’s total allotment volume has been exhausted. Bids at the lowest interest rate level accepted may only be satisfied pro rata. For variable rate tenders with minimum bid rates, there are two methods of allotment: the single rate (or Dutch) auction, and the multiple rate (or American) auction, where the allotment interest rate equals the interest rate offered in each individual bank’s bid.
Until the autumn of 2008, the Eurosystem typically conducted its main refinancing operations on a variable rate tender basis with minimum bid rates and limited allotment volumes using the American auction format.
An alternative auction procedure is the fixed rate tender, in which the interest rate and the total amount of central bank money to be allotted are specified in advance. In their bids, the banks only state the amount of money they wish to transact with the central bank at the fixed interest rate. If the aggregate amount bid exceeds the total amount of central bank money to be allotted, the individual bids are satisfied pro rata.
Since the financial and banking crisis, the Eurosystem has opted for fixed rate tenders with full allotment. Each commercial bank receives the amount of central bank money it wants at the interest rate of the fixed rate tender – provided that the commercial bank can pledge a sufficient quantity of assets accepted by the Eurosystem as collateral.
Eligible collateral
In order to provide the central bank money needed by the banks, the Eurosystem lends to commercial banks via its refinancing operations. To obtain this credit, they need to put up assets as collateral. This is to protect the Eurosystem against potential losses arising from its monetary policy operations: if a bank fails to repay the loan, the Eurosystem can recoup its losses by selling off the underlying assets. Once the Eurosystem has accepted an asset as collateral, it is classified as “eligible”.
The collateral framework consists of assets that can be traded on securities markets, such as bonds of a certain credit quality, as well as non-marketable assets, such as banks’ credit claims on their customers.
The Eurosystem measures the value of underlying assets on a regular basis. The eligibility of assets as collateral for refinancing operations is determined not by their nominal value but by their market value less a haircut. If the underlying assets lose value during the term of the loan, the debtor will need to furnish additional collateral. As a consequence of the crisis, the Eurosystem now accepts a wide range of collateral.
6.3.3 Standing facilities
In addition to open market operations, the Eurosystem offers banks the options of obtaining (marginal lending facility) or depositing (deposit facility) central bank money in the short term. Commercial banks can make use of these standing facilities at any time on their own initiative and at their own discretion. The interest rates on the two standing facilities are also key Eurosystem interest rates. They form an interest rate corridor around the main refinancing operations rate, with the market interest rates at which banks lend to each other generally being somewhere within this corridor.
The two interest rates on the standing facilities are also key Eurosystem interest rates.
Marginal lending facility
The marginal lending facility rate serves as the ceiling…
The marginal lending facility is used by commercial banks to cover their short-term needs for central bank money by taking out an “overdraft” with the Eurosystem. Just like liquidity provided in other refinancing operations, this credit is granted against the submission of collateral. Credit granted under the marginal lending facility must be repaid the next day.
The marginal lending facility rate is normally higher than the main refinancing operations rate and generally serves as the ceiling for the overnight interest rate corridor. This is because no bank with sufficient collateral would pay another bank a higher interest rate for overnight credit than it has to pay to obtain overnight liquidity from the central bank.
Deposit facility
… and the deposit facility rate serves as the floor for the interest rate corridor in the interbank market.
Banks can use the deposit facility to deposit excess liquidity overnight in a special account held with the central bank, remunerated at a fixed interest rate. This interest rate is lower than the main refinancing operations rate applicable at any given time. The deposit facility rate generally serves as the floor for the overnight interest rate corridor and thus prevents this rate from dropping sharply. This is because, under normal circumstances, no commercial bank would lend central bank money to another bank at a lower interest rate than can be obtained from the central bank.
During the crisis, banks increasingly used the deposit facility to park excess funds.
Commercial banks usually try to lend their excess liquidity to other banks in the money market. As the deposit facility rate is normally lower than the overnight money market rate, banks had no incentive to make great use of the deposit facility prior to the onset of the financial and sovereign debt crisis. Following the outbreak of the crisis, this changed for a time. For fear of their counterparties failing, banks were opting to deposit excess funds with the central bank at a lower interest rate rather than lend to other banks at higher rates. Since the start of the Eurosystem’s large-scale asset purchases and the associated drastic increase in excess liquidity in the banking sector, a large amount of central bank money has been deposited in the deposit facility.
6.3.4 Money market management
In times of monetary policy normality, the Eurosystem provides the banking system with precisely the amount of central bank money that it needs by conducting its main refinancing operations. Central bank money is subsequently traded between commercial banks in the money market. The interest rate on overnight money (overnight liquidity from the central bank) is thus close to the main refinancing operations rate.
This, in turn, enables the Eurosystem, by raising or lowering the main refinancing operations rate, to also steer the interest rate on overnight money and thereby indirectly influence all other market interest rates.
If the Eurosystem were to provide less central bank money than the banking system needed, banks would have to make up for the shortfall by using the marginal lending facility, which charges a higher interest rate (and is thus more expensive). This would generally raise the overnight interest rate well above the main refinancing operations rate, meaning that the latter would no longer be the “anchor” for interest rates on overnight money in the money market or other market interest rates.
The Eurosystem influences market interest rates by changing the interest rates on its refinancing operations.
If, however, the banking system were provided with excess liquidity, money would flow into the deposit facility. This would generally cause the overnight interest rate to fall below the main refinancing operations rate – possibly as low as the deposit facility rate.
6.4 Non-standard measures necessitated by the crisis
The Eurosystem has used non-standard monetary policy measures to counteract the effects of the crisis.
Since 2007, the Eurosystem has adopted a range of non-standard measures to counteract the negative effects of the banking, financial and sovereign debt crisis. In doing so, it has always pointed out that these measures cannot solve the underlying causes of the crisis – in particular, the strain on government budgets and banks in some euro area countries. All the measures can do is help stabilise the situation and buy the responsible decision-makers – primarily national governments – some time to make the necessary reforms and structural adjustments.
6.4.1 Full allotment policy
Following the onset of the financial crisis, the interbank market ceased to function as smoothly as it had in the past. Many banks feared that they would suffer losses if one of their counterparties were to become illiquid or insolvent overnight and were therefore reluctant to lend to each other.
Moving to a policy of full allotment helped to avert liquidity shortages among banks during the crisis.
In order to ensure that this development did not result in a large number of banks experiencing simultaneous liquidity shortages, the Eurosystem switched to fixed rate tenders with full allotment for its refinancing operations in October 2008. In these operations, commercial banks receive any amount of money they wish to transact with the central bank at an interest rate set by the ECB Governing Council, provided that they can furnish sufficient collateral that meets Eurosystem requirements. Full allotment led to larger amounts of excess liquidity in the euro area banking system as a whole. In this situation, banks parked their excess funds in the deposit facility, as the Eurosystem does not remunerate excess balances in normal central bank accounts. As a result of the excess liquidity in the banking system to this day, the euro overnight interest rate (EONIA) has been lower – at times far lower – than the main refinancing operations rate for more than ten years.
In June 2014, the ECB Governing Council moved the deposit facility rate into negative territory. Since then, banks that hold central bank money in the deposit facility or as excess reserves in their central bank accounts have no longer been remunerated for these holdings, but instead have to pay interest to the Eurosystem. This is intended to give banks a greater incentive to lend excess central bank money in the money market and ramp up their lending business with customers.
6.4.2 Forward guidance
Using forward guidance, the central bank aims to reduce uncertainty about the future course of monetary policy.
In central bank jargon, forward guidance is a communication strategy that involves the central bank providing the public with specific information about the longer-term orientation of its monetary policy. The central bank uses forward guidance in an effort to reduce uncertainty about the future course of monetary policy and in doing so steer economic agents’ expectations.
The ECB Governing Council moved to this targeted steering of expectations in July 2013 in response to a prolonged period of excessively low inflation. Prior to that point, the Governing Council had typically avoided making statements about the longer-term orientation of its monetary policy. However, forward guidance should not be seen as an unconditional promise with regard to future monetary policy measures either. Instead, the Governing Council reserves the right to change its intended monetary policy at short notice in the event of unexpected developments, should this be necessary in order to maintain price stability.
6.4.3 Purchase programmes
Since 2009, the Eurosystem has launched several programmes for the purchase of certain assets.
Securities markets programme (SMP)
In May 2010, the ECB Governing Council launched the securities markets programme (SMP). This saw the Eurosystem purchase bonds issued by certain euro area countries that were hit especially hard by the crisis. The aim of the programme was to remedy malfunctions in securities markets and restore an appropriate monetary policy transmission mechanism. In total, the Eurosystem purchased securities with a book value of €219 billion under the SMP. The purchase programme was formally terminated in September 2012. The volume of this portfolio has been steadily shrinking ever since, as the government bonds purchased are gradually reaching maturity and thus being redeemed.
Outright monetary transactions (OMTs)
Government bond purchases under the OMT programme are conditional upon agreeing to adjust economic policies.
When the sovereign debt crisis intensified in the summer of 2012, ECB President Mario Draghi announced the following in a much-publicised speech on 26 July: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro.” In September 2012, the Eurosystem launched a new programme for the targeted purchase of bonds issued by certain euro area countries, known as outright monetary transactions (OMTs). The prerequisite for the purchase of government bonds under the OMT programme is that the country in question agrees to adjust its economic policies under a European Financial Stability Facility (EFSF) or European Stability Mechanism (ESM) programme (conditionality). To date, the Eurosystem has purchased no bonds under the OMT programme – that is to say, though it has been in place since the autumn of 2012, it has not yet been activated.
6.4.4 Quantitative easing
As a result of the economic crises, the inflation rate in the euro area has remained well below the ECB Governing Council’s target of below, but close to, 2% over the medium term. Accordingly, the Governing Council has cut key interest rates further and further. The main refinancing operations rate has been set at 0% for several years now.
But even in such a case, monetary policymakers remain capable of effective intervention. In order to further ease its monetary policy stance once interest rates have reached zero, a central bank can influence the market interest rate level via quantitative easing (QE). To this end, the central bank purchases bonds on a large scale.
Quantitative easing is intended to lower long-term interest rates in order to achieve the objective of price stability.
Asset purchases have two major effects. First, central bank money is created when assets are purchased, as central banks pay for them in central bank money. This increases the volume (quantity) of central bank money, which generally increases banks’ scope for lending. Second, the higher demand for securities drives up their market prices. As bond prices rise, bond yields, i.e. the total return they generate, fall. This is because the return an investor receives when a bond reaches maturity derives – in addition to the interest paid – from the difference between the now higher price and the redemption amount determined in advance. Ultimately, these lower yields also lower the general level of interest rates. This is similar to the effect of a traditional policy rate cut, referred to as monetary policy easing. The term “quantitative easing” is derived from the two effects described.
In addition, the lower interest rate level stemming from quantitative easing tends to lead to capital outflows to countries where the interest rate level is higher. Capital outflows of this kind cause the domestic currency to depreciate (falling demand for the domestic currency brings about a decline in the exchange rate), which in turn stimulates exports. This, too, invigorates domestic economic activity. As a result, quantitative easing can raise the inflation rate and move it towards the target.
In January 2015, the ECB Governing Council decided to embark on quantitative easing in the euro area as well through its asset purchase programme (APP), a package comprising a range of individual programmes. Since then, the Eurosystem has been purchasing securities on a large scale from private and – at just over 80% of the total purchase volume, primarily – government and public issuers. Following a ten-month pause in 2019, net APP purchases resumed in November 2019. In addition, the Governing Council decided on 12 March 2020 that it would expand the bond purchases already planned under the APP by adding an envelope of additional net purchases totalling €120 billion until the end of 2020. Its intention was, amongst other things, to counteract the economic impact of the coronavirus pandemic. Overall, Eurosystem holdings of securities purchased under the APP for monetary policy purposes have now risen to €3.1 trillion (as at end-February 2021).
Under the APP, the Eurosystem is purchasing securities on a large scale.
In order to eliminate the possibility of direct government financing by the Eurosystem, government bonds are purchased exclusively on the secondary market. This is the market in which investors trade bonds that have already been issued, e.g. a securities exchange. The Eurosystem may therefore purchase a newly issued government bond only after a given grace period has passed. At the same time, certain rules apply to government bond purchases made under the APP. For example, the purchase volume may not exceed one-third of any given issue or of a euro area country’s total bond issuance. Moreover, governments must meet a certain minimum credit quality threshold.
In terms of volume, the PSPP is the most significant purchase programme.
Of the bond purchases and reinvestments of principal payments from maturing bonds under the public sector purchase programme (PSPP), 80% must be conducted by the national central banks. The NCBs focus here on public sector bonds issued in their home country. The amount purchased by each NCB is determined based on their fully paid-up subscriptions to the ECB’s capital. This means, for example, that the Bundesbank’s share of these bond purchases currently stands at around 26.4%, while the shares for the Banque de France and the Banca d’Italia are 20.4% and 17.0%, respectively. Any losses that might arise would be borne by the NCBs themselves.
The remaining 20% of the purchase volume comprises the ECB’s 10% share of asset purchases – with the ECB also basing purchases on capital shares – and purchases of securities by European institutions, likewise corresponding to 10% of the PSPP. Any losses that were to be incurred on this 20% would be shared.
In light of the coronavirus crisis, the ECB Governing Council decided on 18 March 2020 to launch a temporary pandemic emergency purchase programme (PEPP) to complement the APP. This non-standard monetary policy measure is intended to counter the risks to monetary policy transmission caused by the economic fallout from the coronavirus pandemic and to achieve the Governing Council’s avowed monetary policy objective. In addition to, and separately from, the ongoing APP, purchases totalling €1,850 billion are planned under the PEPP, which has been expanded twice so far. Bonds issued by private and public debtors will be purchased until the Governing Council judges that the coronavirus crisis phase is over, but at least until the end of March 2022. As under the APP, the PEPP uses the NCB capital key as the benchmark for allocating purchases across jurisdictions, though the purchases will be conducted in a more flexible manner to allow for fluctuations in the distribution of purchase flows over time, across asset classes, and among jurisdictions. The same rules for risk sharing and assumption of any losses apply to the PEPP as to the APP: 20% of purchases are subject to risk sharing between the NCBs, whilst each NCB must assume the risks for the other 80% of purchases.
6.5 Backing up monetary policy
The Eurosystem’s express primary objective is to safeguard price stability. But monetary policy operates in an environment in which the decisions of other economic participants – such as governments, trade unions and enterprises – also influence prices. For instance, a government’s fiscal and economic policy affects economic developments and consequently price movements. Wage policy likewise has an impact.
Monetary policy cannot safeguard price stability on its own. It needs to be accompanied by stability-oriented economic, fiscal and wage policies. The Eurosystem’s course of stability therefore requires broad support from other economic policymakers, such as the respective governments and social partners.
Stability-oriented fiscal policy is of particular importance
A stability-oriented monetary policy needs to be accompanied by a stability-oriented fiscal policy, in particular: if public finances are not sound, there is a risk of conflicts arising between fiscal and monetary policy that could jeopardise the objective of monetary stability. The higher the level of government debt, the greater the risk. Specifically, as sovereign debt rises, political pressure grows on the central bank to make the financial burdens associated with public debt more bearable by keeping interest rates as low as possible and potentially devaluing debt in real terms through “a little more inflation”. If, by contrast, government fiscal policy pursues a stability-oriented course, this conflict is nipped in the bud before it even arises. This then makes it easier for the central bank to safeguard price stability.
The importance of government for monetary policy stems not only from its fiscal policy but also from the fact that it accounts for a significant share of aggregate demand. It can raise this demand significantly in the short term, if necessary by means of credit-financed spending programmes. Moreover, government can influence the income of households and enterprises through its tax policy and through public sector wage agreements – thereby supporting or counteracting the central bank’s objective.
Fiscal, tax and economic policy therefore have a major impact on economic activity and, as a result, on price changes. Monetary policy’s task becomes far harder if, in particular, these policy areas act in a procyclical manner, i.e. if they reinforce the business cycle and therefore also price movements rather than countering them. This would be the case, for example, if the government were to provide government subsidies to prospective homebuilders in an already booming housing market in a bid to alleviate a housing shortage.
Social partners with a particular responsibility for stability
Social partners also have a particular responsibility in terms of their wage policies. To be specific, excessive wage increases can quickly lead to a general rise in prices if enterprises pass through the higher wage costs to consumers by upping product prices. There is little that monetary policy can do about these price increases in the short term. This is particularly relevant if these price hikes, in turn, lead to higher wage settlements as employees successfully demand higher wages to offset inflation. More stringent monetary policy measures, which are bound to have a negative impact on aggregate growth and employment, are generally required to stop an inflationary wage-price spiral of this kind.