In the second part of this primer, I discussed how the ECB conducts monetary policy with the aim of achieving price stability in the Eurozone. As shown, the ECB has historically employed three different policy tools to control the price level: open market operations (and more specifically, main refinancing operations), reserve requirements and the so-called standing facilities. Yet the 2010 Eurozone crisis pushed the ECB to adopt a number of unconventional policy measures that it had never tried before in order to preserve the Euro, stabilize the weak economies of the Euro area, reach the 2-percent inflation goal, and boost economic growth in the aftermath of crisis.
- Longer-Term Refinancing Operations
Traditionally, open market operations had short maturities. This means that ECB lent funds to commercial banks with maturities no longer than three months. However, in 2011, the ECB started to provide funds to banks with maturities of up to four years. The aim was to encourage banks to increase their lending to households and businesses, giving a boost to the ailing European economy.
2. Quantitative Easing
Quantitative easing (aka QE) is no doubt the most popular among all non-standard monetary tools employed by the ECB over the last years. It involves the outright purchase of four different types of assets: corporate bonds, government bonds, asset-backed securities and covered bonds. These asset-purchase programs, which started in March 2015, were aimed at boosting the economy in several ways.
For instance, the purchase of corporate bonds was designed to push bond yields down, thereby lowering borrowing costs for firms issuing corporate debt to finance their investments. Similarly, the public-sector purchase program was intended to help those countries with difficulties to find funding in the markets meet their fiscal and debt obligations.
It should be noted that many of these assets are usually held by banks, which means that these purchases increase the amount of reserves in the banking system, incentivizing financial intermediaries to extend new loans to the private sector.
3. Negative Interest Rates
For the first time in history, the ECB cut one of its key rates (the so-called deposit facility rate) into negative territory. As I explained in part two, the deposit facility was established to pay interest to banks for depositing money with the ECB. The rate was positive until 2014, when the Governing Council decided to enter the uncharted waters of negative interest rates.
The rationale behind this policy is simple. In times of economic boom, the ECB usually pays interest to banks for holding excess reserves to disincentive an overexpansion of credit, which tends to lead to inflationary pressures. In contrast, when a crisis hits the economy, the ECB wants banks to extend new credit to the economy. Thus, it penalizes the hoarding of excess reserves by charging banks an interest rate for depositing money with the ECB.
4. Forward Guidance
If there is one unconventional monetary policy tool that has unequivocally proven to be effective, it is forward guidance. In fact, it is used nowadays by most central banks in the world. Forward guidance consists in providing information about the future path of monetary policy to reduce economic uncertainty and allow economic agents to make better decisions.
A paradigmatic example of forward guidance is the now-famous “whatever it takes” speech delivered by Mario Draghi in July 2012. In middle of a financial turmoil (the sovereign bond yields of Southern European countries were soaring, questioning the solvency of Spain, Portugal and Italy), the President of the ECB assured that “the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”
Those words had a remarkable calming effect on markets. As shown in the graph below, 10-year bond yields of periphery countries started to go down in July 2012, right after Draghi’s speech. It should be noted that the purchase of government bonds by the ECB (which was design to push yields down) didn’t begin until 2015, when yields had already decreased dramatically from their 2012 levels. In fact, those words by Draghi had a larger impact on bond yields than the actual purchase of sovereign bonds by the ECB.
In the next article, I will examine the transmission mechanisms of monetary policy, i.e., the ways in which monetary-policy decisions affect the economy.
Luis Pablo de la Horra
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