The Monetary Policy of the ECB
The primary monetary-policy objective of the European Central Bank, ECB, is to maintain price stability in the
euro area. The ECB's monetary policy is therefore based on three main elements: a quantitative definition of
price stability, and two pillars for analysis of data as the basis for the monetary-policy decisions.
In 2000 the ECB raised its official interest rates by a total of 1.75 per cent in order to prevent future inflation
as a consequence of stronger economic growth and oil-price rises. In the autumn of 2000 the ECB, and in one
instance also other central banks, intervened in the foreign-exchange market in support of the euro. The
background was concern about the global and domestic consequences of the falling euro rate against the dollar
and the yen, including the risk of price increases in the euro area.
The monetary policy strategy
Under the Maastricht Treaty the primary objective of the ECB is to maintain price stability in the euro area. The ECB
has defined price stability as a year-on-year increase in the Harmonised Index of Consumer Prices, HICP, for the euro
area of below 2 per cent. The ECB's monetary policy has a medium-term orientation. The ECB's mandate entails that
monetary policy may support the growth potential of the euro area unless this is incompatible with the primary objective
of price stability.
The monetary-policy strategy is based on two pillars which together form the basis for the monetary-policy decisions,
cf. Box 1. The pillars indicate the key factors in the assessment of price developments.
Box 1 The two pillars of the monetary-policy strategy
| Source: |
ECB Monthly Bulletin, November 2000. |
The first pillar
The first pillar comprises an analysis assigning a prominent role to money. The prominent role of money is signalled by
the announcement of a reference value for growth in the broad monetary aggregate, M3. M3 consists of deposits with
credit institutions from private citizens and business enterprises, etc., as well as their holdings of currency in circulation
and negotiable instruments issued by monetary financial institutions.
The reference value is derived from the relationship between money, real income, prices and the velocity of money. The
correlation is as follows in terms of changes:
Dm/m = Dy/y + Dp/p - Dv/v,
where Dm/m is the percentage growth in money, Dy/y is the growth in real income, Dp/p is inflation and Dv/v is the percentage
increase in the velocity of money.
The first reference value was announced in December 1998 as a year-on-year rate of growth of 4½ per cent. This
reference value was derived on the basis of medium-term assumptions of annual trend growth in real income (real GDP)
of 2-2.5 per cent, an underlying annual decline in the velocity of circulation of M3 of 0.5-1 per cent and price trends in
accordance with the ECB's definition of price stability (a year-on-year increase in HICP of below 2 per cent). The
reference value of 4½ per cent was reconfirmed in December 1999 and again in December 2000. At the announcement
in December 2000 the Governing Council noted that the available data was still insufficient to provide any basis for
adjusting the assumption of the trend growth in real GDP despite structural progress in the euro area.
Under normal circumstances strong or persistent deviations of monetary growth from the reference value indicate
upward pressure on prices, but in the short term the deviations can be explained by a range of factors. The ECB does
not regard the reference value as a target to be controlled, but as an analytical tool to assess future inflation. The first
pillar also includes analyses of the development in other monetary aggregates (M1, M2), trends in the various
sub-components of M3, and an analysis of their counterparts on the balance sheets of monetary financial institutions, including growth in lending in particular.
The second pillar
The second pillar comprises an analysis of a number of real-economic and other indicators to assess the risks to price
stability, particularly in the short term and the medium term. These are output, demand and labour-market indicators, the
euro exchange rate, the balance of payments, fiscal-policy and financial indicators, and trends in price and cost indices.
The development in asset prices may also influence price development via the income account.
Under the second pillar macroeconomic projections prepared by the ECB and others also play a role as background
material to the monetary-policy decisions of the Governing Council. In the Monthly Bulletin of December 2000 the ECB
for the first time published macroeconomic projections compiled by ECB economists in cooperation with the national
central banks of the euro area. The ECB states that these projections do not reflect the Governing Council's views or
estimates. In contrast to a forecast the projections assume unchanged monetary policy and thus unchanged official
interest rates and exchange rates. The intention of these assumptions is to clarify any consequences of an unchanged
monetary policy in the projection period. The projections are thus not necessarily the best estimate of future trends,
particularly not in the longer term, since monetary policy will respond to any changes in the price prospects.
The ECB's projections of inflation and growth in real GDP, including sub-components, are published as ranges to
emphasise the uncertainty of the predictions. The uncertainty of the projections increases with the time horizon, which is
reflected in broader ranges.
According to the projections the price-increase rate is expected to decline in the coming years. Since the preparation of
the projections, oil prices have continued to fall and the euro has continued to strengthen. Both factors exert downward
pressure on inflation.
According to the ECB the Governing Council cross checks the projections with other projections and other information
concerning real-economic trends based on available indicators, including expectations of the future.
The ECB's macroeconomic projections for the Euro area
| Annual change, per cent |
19991 |
2000 |
2001 |
2002 |
| Consumer-price index, HICP |
1.1 |
2.3-2.5 |
1.8-2.8 |
1.3-2.5 |
| GDP in constant prices |
2.5 |
3.2-3.6 |
2.6-3.6 |
2.5-3.5 |
| Of which: |
|
| Private consumption |
2.8 |
2.3-2.7 |
2.2-3.2 |
1.7-3.3 |
| Government consumption |
1.4 |
0.8-2.0 |
0.6-1.6 |
0.9-1.9 |
| Gross fixed capital formation |
5.3 |
4.7-5.7 |
3.3-6.3 |
3.1-6.3 |
| Exports (goods and services) |
4.6 |
9.8-12.6 |
6.5-9.7 |
5.6-8.8 |
| Imports (goods and services) |
6.2 |
8.8-11.4 |
6.0-9.4 |
5.3-8.7 |
| Source: |
ECB Monthly Bulletin, December 2000. |
| 1 |
Actual figures. |
Monetary policy must be forward-looking in view of the medium-term orientation of the primary objective. Short-term
price fluctuations do not necessarily call for a monetary-policy response. Cases in point are the effects of adjusting
indirect taxes or the one-off effects of variations in international commodity prices, such as oil prices.
Monetary-policy decisions
Interest-rate adjustments
The rate of increase in consumer prices rose in 2000 due to rising oil prices, a weakening of the effective euro exchange
rate, and increasing import and producer prices. During 2000 the rate of inflation thus exceeded the upper limit of 2 per
cent stated in the ECB's definition of price stability, cf. Chart 15.
Chart 15 Inflation in the Euro area
The stronger activity contributed to a tightening of the labour market during the year.
Throughout 2000 monetary growth exceeded the reference value of 4½ per cent, although the growth rate was
declining during most of the year. Credit to the private sector continued to expand at a high rate, cf. Chart 16.
Chart 16 Growth in m3 and in credit to the private sector in the Euro area
In order to prevent transmission of rising import and producer prices to increased inflation expectations and thereby to
price and wage formation, the ECB raised its official interest rates on 6 occasions in 2000 by a total of 1.75 per cent,
cf. Chart 17.
Chart 17 Official interest rates and money-market interest rates in the Euro area
| Note: |
The main refinancing rate is the minimum bid rate as from 28 June 2000. |
| Source: |
ECB. |
The rates of interest for the two standing facilities, the marginal lending facility and the deposit facility, matched the rate
of interest for the main refinancing operations. As a result, the interest-rate corridor for the day-to-day money-market
interest rate, EONIA, cf. Box 2, was unchanged throughout 2000.
Box 2 The ECB's monetary-policy framework
By means of open market operations credit institutions are supplied with liquidity against collateral. Most of the
liquidity is alloted in the main refinancing operations which are weekly tenders providing liquidity at a maturity of 14
days. Furthermore, the Eurosystem provides liquidity via long-term refinancing operations which are monthly tenders,
providing liquidity at a maturity of three months. The Eurosystem may also apply fine-tuning operations to even out
interest-rate fluctuations, particularly if they are caused by unexpected liquidity fluctuations. Finally, the Eurosystem may
also carry out structural operations to adjust its structural position vis-à-vis the financial sector over a longer period./p>
The standing facilities aim to provide and absorb overnight liquidity. The credit institutions may use the marginal
lending facility to obtain overnight liquidity against collateral, and the deposit facility to make overnight deposits. The
standing facilities are made available via the national central banks of the euro area. The rates of interest on the standing
facilities are normally the limits of EONIA (Euro Overnight Index Average).
Under the Eurosystem's minimum reserve system credit institutions in the euro area are obliged to deposit 2 per cent of
selected liabilities with the national central banks. The reserve requirements must be met on average during a 1-month
maintenance period from the 24th to the 23rd of the following month. The holdings of required reserves are remunerated
at the rate of the Eurosystem's main refinancing operations.
On the last day of each maintenance period the reserve requirement becomes binding, so the EONIA rate may fluctuate
more than usual. Strong fluctuations in the EONIA interest rate towards the end of a maintenance period are typically
due to a liquity shortage among credit institutions with a view to compliance with the reserve requirement. A drop in
EONIA at the end of a maintenance period can be attributed to ample liquidity among the credit institutions.
Foreign exchange
The monetary-policy strategy for the euro area does not include a target for the euro rate. Exchange-rate fluctuations as
such therefore do not evoke monetary-policy adjustments. The euro's exchange rate will result in a monetary-policy
response only in so far as it affects expectations of price and cost developments.
In view of the possible consequences for the world economy of the exchange-rate fluctuations, on 22 September 2000
the ECB, together with the central banks of the USA, Japan, Canada and the UK, intervened in support of the euro.
The ECB intervened on a few more occasions during the first part of November.
In mid-September 2000 the ECB announced that inflows derived from the interest income of the foreign reserve assets
would be sold against euro in order to maintain the structure and risk profile of the ECB's balance sheet as it was at the
beginning of 1999.
The ECB's monetary-policy instruments
With a view to its monetary-policy objective the ECB and the national central banks of the euro area conduct
open-market operations, impose minimum reserve requirements on credit institutions, and offer standing facilities, cf.
Box 2. This operational framework for monetary policy remained unchanged in 2000, with the exception of amendment
of the liquidity allotment procedure in the main refinancing operations.
The main refinancing operations are intended to manage short-term money-market interest rates and the supply of
liquidity to the money market. The main refinancing operations are carried out as weekly tenders supplying liquidity to
the market at a maturity of 14 days against collateral. Until 28 June 2000 liquidity was allotted at a pre-announced fixed
interest rate in connection with the main refinancing operations. However, the fixed-rate tender procedure gave rise to
very high bids and low allotment ratios, cf. Chart 18.
Chart 18 Bid amounts and allotment ratios in the ECB's main refinancing operations
With effect from 28 June 2000 the ECB therefore amended the tender procedure in the main refinancing operations from fixed-rate tenders to variable-rate tenders. Under the variable-rate tender procedure counterparties submit bids for interest rates as well as amounts. The bids with the highest interest rates are accommodated first and are payable at the bid rate (American auction). The ECB then accepts successively lower rates of interest until the desired allotment is reached. The marginal interest rate is the lowest rate at which liquidity is allotted. At the Governing Council's monetary-policy meetings a minimum bid rate is decided. The amendment of the tender procedure from fixed-rate to
variable-rate tenders led to a strong decrease in the bid amounts, and a substantial increase in the allotment ratios. The total allotment of liquidity was virtually unchanged.
| 
