The Monetary Policy and Its Effects on Economy - an European View

“The monetary policy and its effects on economy - an European view”

MSc. Finance and International Business Nicoleta Cristina Alexandru

The monetary policy and its effects on economy - an European view

Academic Advisor: Jan Bartholdy

This paper takes a closer look about how the European Central Bank is conducting the monetary policy in Europe, what are the goals, the instruments, the transmission mechanism and the results. The first chapter makes a theoretical review of what monetary policy means for the Euro Area and the member states. The second chapter studies the concept of financial crises; given the current disruption in the world economy and the past experiences, the review puts into perspective the possible solutions that can be employed in order to avoid a general collapse. The third chapter contains an empirical study with regards to the effect that European Central Bank’s monetary policy measures have in the Euro Area, both for the key euro area indicators and for the non-financial companies.

Chapter 1. The monetary policy of the European Central bank

Introduction

Founded on 30 June 1998 in Frankfurt,the European Central Bank has the responsibility of leading a single monetary policy in the Euro Area, as people in 16 European countries have euro as their currency. Starting 1 January 1999, its main tasks have been to maintain price stability in the Eurozone and to implement the European monetary policy defined by the European System of Central Banks (ESCB). The Executive Board and Governing Council administer the European System of Central Banks (ESCB), whose roles are to manage money supply, conduct exchange operations, hold and manage the official foreign reserve assets of the Member States and ensure the smooth functioning of payment systems[1].

The EC Treaty delegates the ECB and the National Central Banks, associated in the form of Eurosystem, with a clear mandate and a primary objective of maintaining the price stability in the euro area, i.e. preserving the purchasing power of the euro. The achievement of this monetary policy objective is widely proven through economic theory and empirical research to significantly contribute to sustainable growth, economic welfare and job creation.

Basic notions[2]

At a basic, theoretic level, inflation is defined as a general increase in the price of goods and services, in a certain time period and region, leading to a decline in the value of money and their purchasing power; at the same time, deflation is defined oppositely, as a fall in the overall price level over a certain time span and region. Economic evidence, for a wide variety of countries and periods, shows that, in the long run, economies with lower inflation appear on average to grow more rapidly in real terms, as the erosion in the purchasing power of money means a loss of real value in the internal medium of exchange and unit of account in the economy.

On the other hand, episodes of deflation have often been associated with the supply of goods going up (due to increased productivity) without an increase in the supply of money, or the demand for goods going down combined with a decrease in the money supply. The phenomenon of deflation is particularly important to be avoided, given that it implies nominal interest rates to fall below zero, making the lending activity impossible (as the public would prefer to hold cash than to lend or make deposits at a negative rate). In this case, any monetary policy measure taken by the central bank would not be able to sufficiently stimulate the aggregate demand through the interest rate instrument.

A situation of price stability is met if, on average, there is no change in the general price level. Still, frequent movement in the prices of certain good and services are quite normal in market-based economies, as a consequence of technological progress, but in a situation where falls and rises in prices offset each other, the price stability is still maintained. Among the numerous advantages of price stability, one can find reduced uncertainty about price levels and improved transparency of relative prices, reduced inflation risk premia in interest rate, avoidance of unnecessary hedging activities, reduced distortionary effects of tax and social security systems, increased benefits of holding cash, prevention of arbitrary distribution of wealth and income, and overall financial stability.

For obvious reasons, price stability and inflation also make subject of one of the convergence criteria that must be met by each Member State before it can adopt the euro as part of the third state of the Economic and Monetary Union - the average inflation rate of the candidate member should not exceed by more than one and a half percentage points that of the three best performing Member States in terms of price stability on a time period of one year before the examination.

The transmission mechanism through which the actions of the European Central Bank are transmitted through the economy and ultimately to prices is extremely complex and moreover, variable over time. Still, its basic features are clear: as the central bank is the monopolistic issuer of the bank notes and bank reserve, i.e. the so-called “monetary base”, therefore it is able to influence market conditions and short-term interest rates.

In the short run, a change in money market short term interest rates, all things being equal, has an impact on spending and saving decisions of the companies and households, and may also affect the supply of credit. This is mainly possible as policy rates expectations, e.g. the short-term interest rates on loans given to the banks, translate into a wide range of long-term bank and market interest rates. Higher interest will determine households to increase savings as the return in terms of future consumption is higher. At the same time, companies will diminish their investments, as fewer of them will bring a return high enough to compensate the increased cost of capital.

Still, this process implies a certain time lag, as it usually takes month for companies to set up an investment plan, especially for high valued items like industrial plants or high-tech equipment, and, also, many consumers will not change their consuming habits immediately, following movements in interest rates. In conclusion, a monetary policy measure cannot influence economy (e.g. the overall demand for goods and services) in the short run.

The ECB’s Monetary Policy

The idea of a economic monetary union did not appeared at the very first beginning of the European Economic Community in the ‘50s, as the initial idea was to form a customs union and a common agricultural market. Still, the need for a monetary identity was brought in the 1960s, as the international environment and the differences in the European countries’ policy priorities threatened the functioning of the simple union. However, the attempt was not successful, under the pressure of divergent policy responses to the economic shocks of the period and the so-called “snake” (a stable fluctuation margin of ±2.25% around each currency’s central rate vis-à-vis the US dollar) was suspended and the rates fluctuated freely.

A straightforward decision to the integration process came into the European landscape in June 1988, when the objective to gradually achieve economic and monetary union was reconfirmed by the European Council.The president of the European Commission at that time, Jaques Delors, came with a three step plan for the introduction of an Economic and Monetary Union. The first step, launched in 1990, was aiming at reducing the disparities between the economic policies of the member states, intensifying the monetary cooperation and removing all obstacles to financial integration. The second step, beginning 1994, set up the organizational structure of the EMU and strengthened the economic convergence, while starting 1999, in the last stage, the exchange rates were locked irrevocably and all the Community institutions and bodies were be assigned their full monetary and economic responsibilities.

As mentioned before, according to the EC Treaty, the final goal of the ECB’s monetary policy is price stability. In other words, the European Central Bank must influence the money market conditions, i.e. the short term interest rates, in such a way that price stability is maintained in the medium term. Price stability, as it is defined by the EC Treaty, implies a year-on-year increase in the Harmonised Index of Consumer Prices[3] (HICP) of below 2% in the medium term[4].

For this to be possible, inflation expectations must be firmly considered and the national central banks, must, in turn, to elaborate their targets to a systematic and consistent method of conducting monetary policy. Moreover, the exact mechanism and lagged transmission of any policy measure must also be taken into consideration, therefore the strategy should always have a medium term focus, in order to avoid introduction of unnecessary volatility in the economy. However, short-term volatility in the inflation rate is always possible, e.g. due to changes in international commodity prices or direct taxes, so no policy measures can offset unanticipated price shocks.

On the other hand if an excessively aggressive policy carried out to restore price stability within a very short time period could cause a significant cost in terms of output and price volatility that would have a final effect on price developments in the long run. Moreover, the medium term orientation gives the ECB a flexibility of reaction in case of economic shocks that might occur.

All in all, a successful monetary policy takes into account a broad base of relevant information, in order to understand the factors driving economic developments, therefore a small set of indicators or a single economic model is definitely not reliable.

The transmission mechanism

In order to take the best decision regarding monetary policy measures, ECB makes a comprehensive analysis based on two complementary perspectives on the determination of price developments. The first perspective, known as the „economic analysis” implies the assessment of short to medium-term determinants of price developments with a focus on real activity and financial conditions in the economy, as in this time span, the determinants are significantly influenced by the interplay of supply and demand in the goods, services and factor markets.

Among the economic and financial variables that asses the dynamics of real activity and are subject of the above analysis we can find: aggregate demand and its components, fiscal policy, capital and labour market conditions, developments in the exchange rate, financial markets, balance of payments and balance sheet positions of euro area sectors.

The next chart provides an illustration of the main transmission channels of monetary policy decisions, as it is seen by the European Central Bank.

A illustration of the transmission mechanism from interest rates to prices[5]

While price developments in the industrial sector, as measured by producer prices, and labour costs may have a significant impact on price formation and also provide information on the competitiveness of the euro area economy, indicators of output and demand provide information on the cyclical position of the economy. Balance of payments and external trade statistics show the impact of exports and imports on demand conditions and, moreover, to the exchange rate and commodity prices.

Movements in asset prices may affect price development via income and wealth effects, as in case of a e.g. equity price rise, share-owning individuals might chose to increase their consumption, raising domestic demand and, therefore, inflationary pressures, while those who are planning to take a loan could find it more easy to obtain, given the increase in the value of the collateral (in this case, the shares), again with a latter impact on spending and final demand. Moreover, through bond trading, the financial markets participants reveal their expectations about developments in real interest rates and inflation expectations, therefore asset markets and asset prices are forward-looking by nature and can be analysed as such.

Last but not least, developments in the exchange rate have close implications for price stability, through the influence on import prices and, furthermore, on domestic producer and consumer prices . Even if the euro area is a relatively closed economy, the evolution of the exchange rate has another impact on the price competitiveness of the European domestic products on the international markets.

The models in this paper make use of a small part of the above variables: gdp, gdp deflator, an index of commodity prices, final demand, inventories, durable and non-durable goods consumption, residential investment, companies’ investment rate and, from a statement of comprehensive income point of view, corporate profit and employee benefits.

The second perspective, focused on a long-term horizon, is known as the „monetary analysis” and it attaches a more prominent role to monetary and credit developments. This analysisstudies the long-run link between money and prices, being more a means of cross-checking the short/medium-term indicators of the first “economic analysis” from a long/medium-term perspective.

More precisely, the ECB takes into consideration the monetary aggregate M3[6], as empirical evidence confirms this aggregate to have the properties of a stable money demand, being a leading indicator for future price developments in the euro area. Given that, it is considered that an annual growth rate of M3 of 4,5%[7] is considered to be compatible with the price stability over the medium term. Still, this method is only used to analyse and asses the information content of monetary developments in the euro area, as no evidence support the existence of a direct link between short-term monetary developments and monetary policy decisions, therefore if M3 deviates significantly from the 4,5% benchmark, the ECB does not react mechanically.

The rationale behind this behaviour is given by the existence of so-called special factors, such as institutional changes. Modifications in tax treatment of interest income or capital gains shifts the private sector’s preference for money holding (deposits vs. alternative financial instruments), affecting the development of M3 without being necessarily important for the long term evolution of prices.

The two pillar analysis provides a cross-check of the conclusions that appear from the short-term economic analysis, to make sure all the relevant information regarding price developments is taken into consideration, as both asses different risks to price stability.

The combined approach reduces the risk of policy errors cause by the reliance on a single indicator, model or forecast, given that a diversified approach helps carrying a robust monetary policy in an uncertain environment.

Monetary policy instruments[8]

The operational framework through which the monetary policy is carried out within the Eurosystem consists of three categories of instruments: open market operations (of which the main refinancing operation interest rate instrument is closely studied in this paper, both theoretical and empirical), standing facilities and minimum reserves requirements for credit institutions.

Open market operations

The open market operations are used to manage the liquidity situation on the market and, conducting the liquidity rates and signalling the direction of the monetary policy. According to their scope, regularity and procedure, the operation can be divided into four categories: main refinancing operations, longer-term refinancing operations, fine-tuningoperations and structural operations - each with its specific instruments.

The main open market instrument of the Eurosystem consists of reverse transactions and this instrument can be employed in all the above categories of operations. The reverse transactions are operation through which the Eurosystem buys or sells eligible assets under repurchase agreements or conducts credit operations against eligible assets as collateral.

The main refinancing operations (MRO) consist of regular liquidity-providing reverse transactions with frequency and maturity of one week, carried out by the National Central Banks, that normally provide the majority of refinancing to the financial sector, therefore being the most important open market operations conducted by the Eurosystem.

As a response to the severe overbidding developed in the fixed rate tender procedure, the Governing Council of the ECB has decided to switch to variable rate tenders in June 2000, therefore, the minimum announced bid rate was supposed to take over the role played until then by the rate in fixed rate tenders[9].

The procedure was changed back to fixed rate tender procedure in October 2008 as an attempt to steer liquidity towards balance conditions, given the international economic environment and the financial crisis, but, at the same time, to comply with the price stability objective. The modification is meant to remain in place as long as needed.