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Primary objective
The primary objective of the ECBs monetary policy is to maintain price stability. This is the best contribution monetary policy can make to economic growth and job creation.
Strategy
Main elements
The ECBs monetary policy strategy provides a comprehensive framework within which decisions on the appropriate level of short-term interest rates are taken. It is based on some general principles that aim to ensure a successful conduct of monetary policy. The ECBs monetary policy strategy comprises
a quantitative definition of price stability, and a two-pillar approach to the analysis of the risks to price stability.
The external communication of the strategy reflects the diversified approach to monetary policy that the ECB has adopted for its internal decision-making.
Two-pillar approach
In order to best serve its objective of maintaining price stability, the ECB, like any other central bank, needs to thoroughly analyse economic developments. The ECB's approach to organising, evaluating and cross-checking the information relevant for assessing the risks to price stability is based on two analytical perspectives, referred to as the "two pillars": economic analysis and monetary analysis. They form the basis for the Governing Council's overall assessment of the risks to price stability and its monetary policy decisions.
Communication
The strategy also provides a framework for explaining monetary policy decisions to the public in a clear and transparent manner. In this respect, a high degree of transparency does not only help the central bank to carry out its mandate more effectively, but also to ensure accountability to the public.
Decisions
Monetary policy decisions are taken by the ECB's Governing Council. The Council meets every month to analyse and assess economic and monetary developments and the risks to price stability and to decide on the appropriate level of the key interest rates, based on the ECB's strategy.
Implementation
To implement its monetary policy decisions, the Governing Council of the ECB has adopted a set of monetary policy instruments and procedures as laid down in the General documentation on Eurosystem monetary policy instruments and procedures. See the section 'Instruments'
the benefits of price stability are substantial (see benefits of price stability). Maintaining stable prices on a sustained basis is a crucial pre-condition for increasing economic welfare and the growth potential of an economy . the natural role of monetary policy in the economy is to maintain price stability (see scope of monetary policy). Monetary policy can affect real activity only in the shorter term (see the transmission mechanism). But ultimately it can only influence the price level in the economy.
The Treaty provisions also imply that, in the actual implementation of monetary policy decisions aimed at maintaining price stability, the Eurosystem should also take into account the broader economic goals of the Union. In particular, given that monetary policy can affect real activity in the shorter term, the ECB typically should avoid generating excessive fluctuations in output and employment if this is in line with the pursuit of its primary objective.
improving the transparency of the price mechanism. Under price stability people can recognise changes in relative prices (i.e. prices between different goods), without being confused by changes in the overall price level. This allows them to make well-informed consumption and investment decisions and to allocate resources more efficiently; reducing inflation risk premia in interest rates (i.e. compensation creditors ask for the risks associated with holding nominal assets). This reduces real interest rates and increases incentives to invest; avoiding unproductive activities to hedge against the negative impact of inflation or deflation; reducing distortions of inflation or deflation, which can exacerbate the distortionary impact on economic behaviour of tax and social security systems; preventing an arbitrary redistribution of wealth and income as a result of unexpected inflation or deflation; and contributing to financial stability.
While the Treaty clearly establishes the maintenance of price stability as the primary objective of the ECB, it does not give a precise definition of what is meant by price stability.
"Price stability is defined as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%."
The Governing Council has also clarified that, in the pursuit of price stability, it aims to maintain inflation rates below, but close to, 2% over the medium term.
Benefits
The announcement
makes the monetary policy more transparent; provides a clear and measurable yardstick against which the European citizens can hold the ECB accountable; provides guidance to the public for forming expectations of future price developments.
Symmetry
By referring to an increase in the HICP of below 2% the definition makes clear that not only inflation above 2% but also deflation (i.e. price level declines) is inconsistent with price stability.
provide an adequate margin to avoid the risks of deflation. Having such a safety margin against deflation is important because nominal interest rates cannot fall below zero. In a deflationary environment monetary policy may thus not be able to sufficiently stimulate aggregate demand by using its interest rate instrument. This makes it more difficult for monetary policy to fight deflation than to fight inflation. take into account the possibility of HICP inflation slightly overstating true inflation as a result of a small but positive bias in the measurement of price level changes using the HICP. provide a sufficient margin to address the implications of inflation differentials in the euro area. It avoids that individual countries in the euro area have to structurally live with too low inflation rates or even deflation.
Ultimately, inflation is a monetary phenomenon. Prolonged periods of high inflation are typically associated with high monetary growth. While other factors (such as variations in aggregate demand, technological changes or commodity price shocks) can influence price developments over shorter horizons, over time their effects can be offset by a change in monetary policy.
Affects expectations
Expectations of future official interest-rate changes affect medium and long-term interest rates. In particular, longer-term interest rates depend in part on market expectations about the future course of short-term rates. Monetary policy can also guide economic agents expectations of future inflation and thus influence price developments. A central bank with a high degree of credibility firmly anchors expectations of price stability. In this case, economic agents do not have to increase their prices for fear of higher inflation or reduce them for fear of deflation.
currency (banknotes and coins) in circulation, the reserves held by counterparties with the Eurosystem, and recourse by credit institutions to the Eurosystems deposit facility.
These items are liabilities in the Eurosystems balance sheet. Reserves can be broken down further into required and excess reserves. In the Eurosystems minimum reserve system, counterparties are obliged to hold reserves with the national central banks (NCBs). Beyond that, credit institutions usually hold only a small amount of voluntary excess reserves with the Eurosystem. By virtue of its monopoly, a central bank is able to manage the liquidity situation in the money market and influence money market interest rates.
Guiding principles
The operational framework of the Eurosystem is based on the principles laid down in the Treaty on the Functioning of the European Union. Article 127 of that Treaty states that in pursuing its objectives, the Eurosystem "() shall act in accordance with the principle of an open market economy with fre e competition, favouring an efficient allocation of resources ()". In addition to the principles set out in the Treaty on the Functioning of the European Union, the operational framework follows several guiding principles.
Operational efficiency
The most important principle is operational efficiency. It can be defined as the capacity of the operational framework to enable monetary policy decisions to feed through as precisely and as fast as possible to short-term money market rates. These in turn, through the monetary policy transmission mechanism, affect the price level.
Another principle is that credit institutions must be treated equally irrespective of their size and location in the euro area. The harmonisation of rules and procedures helps to ensure equal treatment by trying to provide identical conditions to all credit institutions in the euro area in transactions with the Eurosystem.
Decentralised implementation
One principle specific to the Eurosystem is the decentralised implementation of monetary policy. The ECB coordinates the operations and the national central banks (NCBs) carry out the transactions.
The Eurosystem's instruments The operational framework of the Eurosystem consists of the following set of instruments: open market operations, standing facilities, minimum reserve requirements for credit institutions.
Participation The monetary policy framework strives to ensure the participation of a broad range of counterparties. Only institutions subject to minimum reserves may have access to the standing facilities and participate in open market operations based on standard tenders. For outright transactions, no restrictions are placed a priori on the range of counterparties.
Open market operations Open market operations play an important role in steering interest rates, managing the liquidity situation in the market and signalling the monetary policy stance. Five types of instruments are available to the Eurosystem. The most important instrument is reverse transactions, which are applicable on the basis of repurchase agreements or collateralised loans. The Eurosystem may also make use of outright transactions, issuance of debt certificates, foreign exchange
swaps and collection of fixed-term deposits. Open market operations are initiated by the ECB, which decides on the instrument and on the terms and conditions. It is possible to execute open market operations on the basis of standard tenders, quick tenders or bilateral procedures.
Main refinancing operations are regular liquidity-providing reverse transactions with a frequency and maturity of one week. They are executed by the NCBs on the basis of standard tenders and according to a pre-specified calendar. The main refinancing operations play a pivotal role in fulfilling the aims of the Eurosystem's open market operations and normally provide the bulk of refinancing to the financial sector. Longer-term refinancing operations are liquidity-providing reverse transactions that are regularly conducted with a monthly frequency and a maturity of three months. Longer-term refinancing operations that are conduced at irregular intervals or with other maturities, e.g. the length of one maintenance period, six months, twelve months or thirty-six months are also possible. They are executed by the NCBs on the basis of standard tenders and according to a pre-specified calendar. These operations aim to provide counterparties with additional longer-term refinancing. As a rule, the Eurosystem does not intend to send signals to the market by means of these operations and therefore normally acts as a rate taker. On some occasions and under exceptional market circumstances the ECB has also conducted longer-term refinancing operations at a fixed rate (i.e. the Eurosystem did not act as a rate taker). Fine-tuning operations can be executed on an ad hoc basis to manage the liquidity situation in the market and to steer interest rates. In particular, they aim to smooth the effects on interest rates caused by unexpected liquidity fluctuations. Fine-tuning operations are primarily executed as reverse transactions, but may also take the form of outright transactions, foreign exchange swaps and collection of fixed-term deposits. The instruments and procedures applied in the conduct of fine-tuning operations will be adapted to the types of transactions and the specific objectives pursued in performing the operations. Fine-tuning operations will normally be executed by the NCBs through quick tenders or bilateral procedures. The Eurosystem may select a limited number of counterparties to participate in finetuning operations. Structural operations can be carried out by the Eurosystem through reverse transactions, outright transactions and issuance of debt certificates. These operations will be executed whenever the ECB wishes to adjust the structural position of the Eurosystem vis--vis the financial sector (on a regular or non-regular basis). Structural operations in the form of reverse transactions and issuance of debt instruments will be carried out by the NCBs through standard tenders. Structural operations in the form of outright transactions will be executed through bilateral procedures.
Standing facilities
Standing facilities aim to provide and absorb overnight liquidity, signal the general monetary policy stance and bound overnight market interest rates. Two standing facilities, which are administered in a decentralised manner by the NCBs, are available to eligible counterparties on their own initiative.
Deposit facility
Counterparties can use the deposit facility to make overnight deposits with the NCBs. The interest rate on the deposit facility normally provides a floor for the overnight market interest rate.
Minimum reserves Minimum reserves are an integral part of the operational framework for the monetary policy in the euro area. The intent of the minimum reserve system is to pursue the aims of stabilising money market interest rates, creating (or enlarging) a structural liquidity shortage and possibly contributing to the control of monetary expansion. The reserve requirement of each institution is determined in relation to elements of its balance sheet. In order to pursue the aim of stabilising interest rates, the Eurosystem's minimum reserve system enables institutions to make use of averaging provisions. This implies that compliance with the reserve requirement is determined on the basis of the institutions' average daily reserve holdings over a maintenance period of about one month. The reserve maintenance periods start on the settlement day of the main refinancing operation (MRO) following the Governing Council meeting at which the monthly assessment of the monetary policy stance is pre-scheduled. The required reserve holdings are remunerated at a level corresponding to the average interest rate over the maintenance period of the main refinancing operations of the Eurosystem.