A European Central Bank Primer (II): How does the ECB conduct monetary policy?
A European Central Bank Primer (II):  How does the ECB conduct monetary policy?

In a previous article, I talked about the objective, organizational structure and responsibilities of the European Central Bank. Today, I aim to discuss how the ECB conducts monetary policy in the Eurozone. But let me start by discussing more in detail the price-stability objective and why it matters.

For the ECB, price stability means “a year-on-year increase in the Harmonized Index of Consumer Prices (HICP) for the euro area of below 2%.” You might be wondering how come the objective of stable prices involves a yearly increase of nearly 2% in the price level. This isn’t a minor issue. After all, a 2% increase in prices every year results in the price level doubling every 35 years.

This counterintuitive interpretation of price stability has to do with central banks’ fear of deflation, which could be defined as a general fall in the price level resulting from a decline in aggregate spending[1]. Deflationary scenarios have been historically associated with deep economic and financial crises (e.g., the Great Depression). As a result, the ECB tries to avoid deflationary pressures by targeting a relatively-small increase in the price level.

But why is price stability (however we define it) so important? Simple: because it helps anchor the expectations of consumers and businesses, removing price-level uncertainty and facilitating economic calculation. Let me give you an example. If a bank believed that inflation was going to rise uncontrollably over the next decade, do you think it would be willing to make a loan to a business knowing that, by the time the bank gets its money back, this will be worth much less? Obviously not. The same reasoning can be applied to other economic agents. Price stability is thus essential to make sound investment and consumption decisions.

The ECB bases his policies on the idea that changes in the money supply (the amount of money in circulation, including bank reserves and money substitutes like deposits) have an impact on the price level. This is what economists call the neutrality of money: an increase or decrease in the money supply cannot affect long-term economic growth (i.e., it cannot make the economy more productive), but it does influence the price level. We will explain how this mechanism works further below.

The ECB possesses several tools aimed at controlling the amount of money in the economy in order to achieve its price-stability goal. First, the ECB can increase or decrease the monetary base via open market operations, which consist in the provision of liquidity to the banking system. The most important are the so-called main refinancing operations (MRO) through which the ECB influences market interest rates, and more specifically, the rates at which banks lend to each other in the interbank lending market.

MRO work as follows. For the sake of the explanation, let’s assume that the ECB aims to expand the monetary base (i.e., print new euros). The ECB sets an interest-rate target for the interbank lending market compatible with its price-stability goal. It then lends money to banks against collateral (usually short-term government bonds) at a fixed or variable interest rate (the so-called MRO rate). This increases the amount of bank reserves, pushing down the rates at which banks lend to each other  (more funds available from which to borrow result in lower interest rates). The ECB continues to expand the monetary base until it reaches its interest-rate target. 

As long as demand for credit continues to grow[2], increasing reserves should have an expansionary effect on banks’ balance sheets: banks will increase their lending to the private sector, thereby increasing the money supply as new deposits are created in the process of lending[3]. This in turn will lead to more investment and consumption, pushing prices up until reaching the level desired by monetary authorities. 

Second, the ECB can adjust the minimum reserve requirements for banks. Banks are compelled to maintain a fraction of deposits in cash reserves to avoid illiquidity issues. The lower the reserve requirements, the more reserves banks will have available to fund new loans[4]. Finally, the ECB provides two standing facilities: the marginal lending facility and the deposit facility. Banks can resort to the former if they run out of cash reserves at the end of the day and can’t obtain them in the interbank lending market. The deposit facility pays interest to banks for depositing money with the ECB. The lower these rates, the higher the incentives for banks to expand the money supply.

As shown, the ECB fine-tunes three different interest rates (the MRO rate, the deposit facility rate and the marginal lending facility rate) in order to influence market rates and achieve the 2%-inflation goal. In addition, it can increase or reduce the minimum reserve requirements to adjust the total amount of reserves in the system. However, over the last years, the ECB has drawn upon non-conventional monetary tools that it had never used before. I will examine these tools in the next article.  


[1] There is another type of deflation (supply-side deflation) that results from productivity increases (i.e., decreases in production costs). Many economists consider supply-side deflation positive as it is the result of economic growth. See, for instance, this article by George Selgin: https://www.alt-m.org/2016/05/16/monetary-policy-primer-part-4-stable-prices-vs-stable-spending/.

[2] Low interest rates, low economic and political uncertainty and expectations of future profits tend to increase demand for credit.

[3] Contrary to conventional wisdom, banks don’t need new deposits or reserves to make new loans. On the contrary, banks create new deposits (expand the money supply) every time they give out a loan. This doesn’t mean, however, that banks can expand their balance sheets indefinitely. Imagine that bank A gives out a new loan to a business that plans to use the money to buy a new machine. After making the purchase, the funds will be transferred from bank A to bank B, where the seller of the machine has an account.  At the end of the day (when settlement among banks takes place), bank A will need to have enough reserves (or at least borrow them from other banks or the ECB) to settle its debt with bank B.

[4] As pointed out in the previous footnote, this doesn’t mean that banks lend their own reserves. Instead, they use them to settle their debts with other financial institutions. Yet a higher level of reserves allows banks to expand their balance sheets provided that there exists demand for new credit.

Luis Pablo de la Horra

Luis Pablo de la Horra
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