Monetary Policy. The Role of the European Central Bank

Table of Contents

Introduction

Goals of the ECB Monetary Policy
Stability of Prices
A quantitative approach on Price Stability
The definition of price stability
The benefits of price stability

The role of Strategic Monetary Policy of European Central Bank

The approach based on two pillars

The Monetary Analysis

Economic Analysis

Cross-checking information from the two pillars

The measures taken by the ECB to tackle crisis

Discussion

References

Introduction

Monetary policy is the process by which the monetary authority of an economic area, checks the quantity and the cost of money in the economy. The official goals of monetary policy are the control of inflation, the growth of the economy, the reduction of unemployment and the control of the exchange rate in relation to foreign currencies (Boivin et al., 2008). Monetary policy may be expansive, namely to increase the amount of money in the market by encouraging the economic development, but causing an increase in the inflation, or be limiting, i.e. to reduce the amount of money in the market, by keeping inflation low.

In Euro Zone, monetary policy is pursued by the European Central Bank (ECB), which was created with the birth of the euro, when it took over the responsibility for the design and practice of monetary policy by the central banks of the Eurozone countries and operates as an independent, supranational but European organization.

The aim of the present paper is to present monetary policy of the ECB and record the changes in this policy caused by the recent economic crisis from 2007 onwards.

Goals of the ECB Monetary Policy

Stability of Prices

The primary goal of the Eurosystem and the Single Monetary Policy for which it is responsible, is price stability. This objective is institutionally guaranteed by Article 127 of the Treaty on the Operation of the EU (ECB, 2014a), and is the key provision in the chapter of the Treaty for the operation of the EU, which concerns the Monetary Policy (ECB, 2013).

In addition, the Treaty on the Operation of the European Union defines the hierarchy of the Eurosystem's objectives, making it clear that making sure price stability is a very important contribution of the monetary policy to achieve a good economic environment and high rate of employment (ECB, 2014a). Indeed, a large number of economic papers and studies as well as years of practical experience, support that monetary policy can have high contribution in the improvement of economic prospects and rising of citizens’ standard of living of citizens, through the maintenance of price stability (Scheller, 2006). Therefore, the maintenance of stable prices is the only feasible goal of the single Monetary Policy in the medium term. Instead, in addition to the positive effects as to price stability, monetary policy can not exercise a lasting influence on real variables (ECB, 2013).

A quantitative approach on Price Stability

As a general text of principles and objectives, the Treaty on the Functioning of the EU provides simply price stability as a general and unique, essentially, EU goal. The specialization of what specific quantitative content this goal has, was given to the ECB, which following a decision of its Board on October 13, 1998, suggested a quantitative definition of price stability (Iordanides, 2012).

Three were the main reasons for selecting a quantitative approach:

a) The definition adds transparency to monetary policy.
b) A quantitative definition gives a measure against which people can control ECB for its actions. As it is easy to identify price development deviations from price stability, the ECB must be accountable for its ongoing deviations from the definition and provide explanations on how to restore price stability within a reasonable period.
c) The purpose of the definition is to guide expectations for the future development of prices, thus enhancing the reliability and efficiency of the ECB's monetary policy. The dominant commitment of the ECB to preserve price stability provides the financial markets and the general public a good cause to expect that medium-term inflation will be limited in a framework compatible with price stability. Thus, stabilization of the longest -term expectations on inflation allows businesses, trade unions and individual actors who are in the process of setting wages and prices, to avoid to take into account on their decisions higher levels of inflation, which would make difficult the maintenance of price stability (Scheller, 2006).

The definition of price stability

In October 1998, as mentioned above, the Board of Directors of the European Central Bank stated that price stability is considered as a year-on-year increase in the Harmonized Index of Consumer Prices HICP in the euro area, in less than 2% (Zahariades-Souras, 2004). The Board even acknowledged that any monetary policy tools affect the general price level with considerable time lag and with significant uncertainty as to the intended reactions, so the Monetary Policy can not be used the Monetary Policy for fine tuning of developments in the price level (Zahariades- Souras, 2004).

The Board ECB on May 8 2003 (Iordanides, 2012) after having confirmed this definition following an analytical evaluation of the ECB's monetary policy strategy (Scheller, 2006), added – to the above definition - that "price stability as an objective, should be pursued in the medium term rather than tin the short-term of few weeks or months, keeping inflation to remain below, but close to 2% »(ECB, 2014b). Thus setting the quantitative target "Inflation ≤ 2% annually" the ECB acknowledges that no monetary policy, no matter how anti- inflationary may be, is unable to avoid short turbulence in the prices of more than 2% (Zahariades-Souras, 2004).

The reference to the Harmonised Index of Consumer Prices (HICP) for the euro area shows two issues: first, that the objective of the ECB's monetary policy is price stability in the Eurozone as a total and, secondly, that it depicts the common interest of the public for consumer prices (Sheller,2006).

The adoption of the medium-term goal of 2% implies not only the clear self commitment and signaling of the ECB's dispositions towards all the entities of the Eurozone, but at the same time and on the part of the acceptance that the known zero inflation perception is impossible and undesirable, in the sense that a smoothly development path in the Eurozone must accept the development promoting effect of a small price increase, for example less than 1.5% or 1% (Zahariades-Souras, 2002).

Therefore, it was added and the term "proximal" in order to create a safety margin above zero inflation to provide protection from risks of reducing the general level of prices (deflation) (Iordanides, 2012).

It is worth noting that it is important to avoid deflation because it poses to the economy similar costs such as inflation. Furthermore, the moment it occurs, it may be established, since nominal interest rates cannot be reduced below zero. To calculate the safety margin, the ECB took into account studies, which have tried, aiming at different inflation levels, to evaluate the likelihood of nominal rates to reach the lower zero limit. The results in this field differ to some extent, because they depend on various specific cases. However, according to the available studies, the chances are reduced a lot when the central bank targets at an inflation level above 1% (Sheller, 2006).

The benefits of price stability

The goal of price stability concerns the general level of prices of the economy and wants to avoid both extended inflation and deflation, as mentioned previously. According to the reasoning of the Member states of the European Union that agreed on this target, the Price Stability contributes in a number of ways to the achievement of high rates of economic activity and employment (ECB, 2004), because:

i) It allows both consumers and businesses to make their decisions by operating in an environment of stability, information and transparency of relative prices. Therefore, it allows market forces to allocate productive resources in the most efficient manner and finally allowing the growth and expansion of productive capacity of the EU economy (Zahariades-Souras, 2002 & 2004).

ii) It prevents the inflationary increase of the so-called "risk premium" to real interest rates in the economy, since those who hold securities for long intervals do not need to seek further increased rates as compensation for the risk reduction in the real value of assets from the inflationary gnawing (Zahariades-Souras, 2002 & 2004).This way, monetary policy can contribute to the efficient allocation of resources from the capital market and thus increases the incentives for investment (ECB, 2004). This in turn promotes job creation and it generally enhances economic prosperity (Gerdesmeier, 2011).

iii) The credible maintenance of price stability also reduces the likelihood that people and businesses will take resources from productive activities to protect against inflation. For instance, in a high inflationary climate, it is logical to notice an accumulation of real goods since in such circumstances, they maintain better their value than money or certain financial assets. However, accumulating goods is not a good investment decision, and therefore, economic development is hindered (ECB, 2004; Scheller, 2006).

iv) Tax and welfare systems can create negative incentives that deform economic behavior. In most cases, this deform is enhanced by inflation or deflation, as fiscal systems usually do not enable the indexation of tax rates and social security contributions. For example, wage increases designed to compensate workers for an eventual rise of inflation, could have resulted in an increase in the tax rate of employees. There is in this way an automatic progressivity of the tax system. Price stability reduces the distortive effects connected with the impact of the evolution of inflation or deflation in tax systems and social security (Gerdesmeier, 2011)

v) Inflation can be explained as a hidden tax on holding cash. When the price level increases, people who hold cash notice that the actual amount of their money is reduced and therefore, their real financial wealth, as if the had lost a part of their money due to taxation.

Thus, the higher the expected level of inflation and, consequently, the higher the nominal interest rates, the lower the demand for cash by families and invidividuals. This occurs even when there is uncertainty about inflation, i.e. when inflation is fully anticipated. Due to this fact, people are forced to frequently visit banks for taking money when they hold a smaller amount of cash. The additional labor and the cost implied by this fact, it is often described metaphorically as the "wear costs" of inflation. More generally, the reduction of cash holdings is considered to increase the transaction costs (Gerdesmeier,2011).

i) It prevents the frequent and sometimes violent redistribution of wealth and of incomes among social or economic groups, which hold or not assets in the form of securities or other material goods (property, cash etc.) (Zahariades- Sourlas, 2002 & 2004) and which is obtained both from an inflationary and deflationary environment (ECB, 2004). This is especially true when changes in the price level are difficult to be predicted and concern more social categories who have difficulty to protect their nominal claims against inflation. As a rule, poorer social groups are most affected by inflation or deflation, as they have less possibilities of compensating risk. Therefore, stable prices help to maintain social consistency and stability (Gerdesmeier, 2011).

vii) It strengthens financial stability. Sudden adjustments of the value of assets due to non-expected changes in inflation can mine the robustness of the financial situation of banks. For example, if a bank gives long-term loans with fixed rates, which are funded by short-term time deposits, in a non-expected rise in inflation, it will reduce the real value of its assets. Therefore, the bank may meet solvency problems, which can bring negative chain reactions. If monetary policy preserves price stability, there is avoidance of inflationary and deflationary shocks to the real value of nominal assets and, therefore, financial stability is augmented (Gerdesmeier, 2011)

Certainly there are many more advantages that stability of prices will bring in a society. However, it should be noted is that price stability helps to achieve the overall economic objectives, such as higher levels of living, a higher level of economic physical activity and of course, job growth (Dougekos, 2008) and therefore, it contributes to social and economic cohesion which is a declared and predominant objective of the overall EU economic policy (Zahariades-Souras, 2002 & 2004). Several times during the 20th century, it has been found that high levels of inflation or deflation may cause social and political instability (ECB, 2013).

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