Monetary policy of the ECB, its concepts and tools

Frankfurt am Main, 20 September 2011

Markus A. Schmidt Directorate Monetary Policy

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Disclaimer

The views expressed are those of the presenter and should therefore not necessarily be viewed and not be reported as representing the views of the European Central Bank.

Outline

The ECBs monetary policy

Principles of the ECBs monetary policy Economic Analysis Monetary Analysis The monetary transmission process

ECBs response to the crisis

Outline

The ECBs monetary policy

Principles of the ECBs monetary policy Economic Analysis Monetary Analysis The monetary transmission process

ECBs response to the crisis Anything else?

ECBs monetary policy objective

Article 127 of the Treaty of the Functioning of the European Union: The primary objective of the ESCB [Eurosystem] shall be to maintain price stability Without prejudice of the objective of price stability, the ESCB [Eurosystem] shall support the general economic policies with a view to contributing to the achievement of the objectives of the Union as laid down in Article 3 of the Treaty on European Union.
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ECBs quantitative definition of price stability

The Governing Council [GovC] of the ECB in October 2008 defined price stability as
a year-on-year increase of the Harmonised Index of Consumer Prices [HICP] for the euro area below 2%. Price Stability is to be maintained over the medium term.

The GovC aims to maintain inflation rates at levels below, but close to, 2% over the medium term.
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Why below, but close to, 2%?

Below in order to fully reap the benefits of price stability.

Close to to ensure an adequate margin that

avoids risks of deflation, addresses implications of inflation differentials among euro area Member States and takes possible small measurement bias in HICP into account.

Why is price stability important

Inflation is
hampering the price mechanism (absolute-relative confusion, permanent-transitory confusion), is affecting the allocation of income (debtors vs. creditors, wagelag hypothesis) in case of non-anticipated inflation, causes a decrease in efficiency, even if inflation is anticipated, results in sub-optimal holdings of money, reducing households purchasing power.

Purchasing power of 100 Euro (2011) 100 120 20 40 60 80 0

Source: ECB calculations.

Annual inflation rate of... 1% 2% 3% 4% 5%

Inflations consequences for purchasing power

20 11 20 13 20 15 20 17 20 19 20 21 20 23 20 25 20 27 20 29 20 31 20 33 20 35 20 37 20 39 20 41 20 43 20 45 20 47 20 49 20 51 20 53 20 55 20 57 20 59 20 61

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Purchasing power of 100 Euro (2011)

40

60

80

100

120

Inflation and inflation expectations

Long-term inflation expectation (5y5y forward inflation swap rate) Medium-term inflation expectation (5y spot inflation swap rate) Short-term inflation expectations (1y spot inflation swap rate) HICP (annual growth rate, percentage points) 5.0 5.0

4.0

4.0

3.0

3.0

2.0

2.0

1.0

1.0

0.0

0.0

-1.0 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Jun-11

-1.0

Source: Bloomberg, ECB and ECB calculations. Latest observation: September 2011, end-of-month data (inflation swaps) and monthly data (HICP), percentage points.

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Safeguards for sound monetary policy

Institutional safeguards
Clear mandate: Price stability as primary objective Independence from political influence Clear allocation of responsibilities

Strategic safeguards
Credible commitment towards mandate Consistent framework for analysis and decision-making Clear and transparent communication

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The ECBs monetary policy strategy

Primary objective of price stability
Governing Council takes monetary policy decisions based on an overall assessment of the risks to price stability

Economic analysis

Monetary analysis

Analysis of economic dynamics and shocks

cross checking

Analysis of monetary trends

Full set of information

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Key principles of the ECBs monetary policy strategy

Forward-looking nature

Medium-term orientation

Broad-based analysis

Cross-checking of analyses

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Outline

The ECBs monetary policy

Principles of the ECBs monetary policy Economic Analysis Monetary Analysis The monetary transmission process

ECBs response to the crisis Anything else?

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Economic Analysis
The Economic Analysis aims at identifying short- to medium-term risks to price stability. Forward-looking assessment of relevant information from a variety of indicators (e. g. business cycle, wages, exchange rate, asset prices, financial yields, fiscal policy, etc.). Quarterly macroeconomic projections for inflation and growth in the euro area, prepared by staff of the Eurosystem/ ECB
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Economic Analysis
The scope of the Economic Analysis are factors determining supply- and demand-conditions on
goods markets, services markets, and factor markets [capital markets, labour markets].

It investigates shocks to the economy, the resulting dynamic processes as well as the perspectives stemming from that.

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Economic Analysis
Among the indicators relevant for Economic Analysis are
price indicators, expenditure components, production indicators, sentiment indicators, labour market indicators and financial market indicators.

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Outline

The ECBs monetary policy

Principles of the ECBs monetary policy Economic Analysis Monetary Analysis The monetary transmission process

ECBs response to the crisis Anything else?

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Monetary Analysis
The Monetary Analysis aims at identifying medium- to longer-term risks to price stability. The basis of Monetary Analysis is the conviction that inflation is always a monetary phenomenon, at least in the long-run. Money has leading indicator properties for inflation in the euro area in the medium- to long-run. Regular monitoring of money and credit developments contributes to identifying emergence of unsustainable developments in asset prices.
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Monetary Analysis
M M* P* P

M* M* M*

P
P* P* P*

t
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Monetary Analysis
Monetary Analysis is mainly based on balance sheet data of the money-issuing sector, i.e. so-called Monetary Financial Institutions [MFIs].
Assets Credit to general government
Loans Securities

Liabilities Currency in circulation Overnight deposits Other short term deposits Marketable instruments Holdings of central government Longer term liabilities

Credit to private sector

Loans Securities

Net claims on non-euro area residents Securities

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Credit is the main source of monetary dynamics

Loans to the private sector (adjusted for securitisation) 14 M3 14

12

12

10

10

-2 Jul-00 Jul-01 Jul-02 Jul-03 Jul-04 Jul-05 Jul-06 Jul-07 Jul-08 Jul-09 Jul-10 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jul-11

-2

Source: ECB. Latest observation: July 2011, monthly data, annual growth rates, percentage points.

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Outline

The ECBs monetary policy

Principles of the ECBs monetary policy Economic Analysis Monetary Analysis The monetary transmission process

ECBs response to the crisis Anything else?

23

The monetary transmission process

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Monetary transmission in normal times

Overnight rate mirrors official key interest rate over maintenance period. ECB influences money market conditions by setting key interest rates and managing the liquidity situation in the banking sector by benchmark allotment. Banks with liquidity surplus lend to those with deficits over inter-bank money market. Government bonds play an important role as collateral and for the pricing of fixed income securities, hence availability is important.
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Steering money market conditions

Main refinancing operations % 7 Marginal lending facility Deposit facility Eonia (monhtly average)
7 %

0
Fe b0 Au 0 g0 Fe 0 b0 Au 1 g0 Fe 1 b0 Au 2 g0 Fe 2 b0 Au 3 g0 Fe 3 b0 Au 4 g0 Fe 4 b0 Au 5 g0 Fe 5 b0 Au 6 g0 Fe 6 b0 Au 7 g0 Fe 7 b0 Au 8 g0 Fe 8 b0 Au 9 g0 Fe 9 b1 Au 0 g1 Fe 0 b1 Au 1 g11
Source: ECB. Latest observation: August 2011, monthly averages of daily observations

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Steering money market conditions

Long-term interest rate (10 y) % 6 Short-term interest rate (3 m) Eonia (monhtly average) 6 %

Fe b0 Au 0 g0 Fe 0 b0 Au 1 g0 Fe 1 b0 Au 2 g0 Fe 2 b0 Au 3 g0 Fe 3 b0 Au 4 g0 Fe 4 b0 Au 5 g0 Fe 5 b0 Au 6 g0 Fe 6 b0 Au 7 g0 Fe 7 b0 Au 8 g0 Fe 8 b0 Au 9 g0 Fe 9 b1 Au 0 g1 Fe 0 b1 Au 1 g11
Source: ECB. Latest observation: August 2011, monthly averages of daily observations

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Outline

The ECBs monetary policy

Principles of the ECBs monetary policy Economic Analysis Monetary Analysis The monetary transmission process

ECBs response to the crisis Anything else?

29

The financial turmoil and the money market

Eurepo (3M) %
7

Euribor (3M)

Depo-Repo-Spread (3M, RHS)

210 bp

180

150

120

90

60

30

0 May-07 May-08 May-09 May-10 May-11 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Nov-10 Jul-11 Nov-09 Nov-08 Nov-07 Sep-07 Sep-08 Sep-09 Sep-10 Sep-11 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jul-07 Jul-08 Jul-09 Jul-10

Source: Bloomberg and ECB calculations. Last observation: 15 September 2011, daily observations

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Impairment of the monetary transmission process

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The ECBs response to the crisis

Immediate response on 9 August 2007
Allowed banks to draw full amount of what they needed on overnight basis against collateral at the prevailing main refinancing rate (ca 95 bn)

In the following months

Supplementary refinancing operations with 3 and 6 months maturity Intra-maintenance period frontloading More frequent fine-tuning operations Provision of US dollar liquidity against euro-denominated collateral
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Liquidity management measures

Pre-crisis benchmark allotment
[EUR billions]
[EUR billions]

Pre-Lehman frontloading
300.0 280.0 260.0 240.0 220.0 200.0 180.0 160.0 140.0 120.0 100.0

300.0 280.0 260.0 240.0 220.0 200.0 180.0 160.0 140.0 120.0 100.0
11/07/07 14/07/07 17/07/07 20/07/07 23/07/07 26/07/07 29/07/07 01/08/07 04/08/07 07/08/07

08/08/07

11/08/07

14/08/07

17/08/07

20/08/07

23/08/07

26/08/07

29/08/07

01/09/07

04/09/07

07/09/07

10/09/07

Daily current accounts

Reserve requirements

Daily current accounts

Reserve requirements

Post-Lehman ample liquidity

EUR [billions] 500.0 450.0 400.0 350.0 300.0 250.0 200.0 150.0 100.0 10/12/08

Reserve requirement Reserve holdings Recourse to deposit facility

14/12/08 18/12/08 22/12/08 26/12/08 30/12/08 03/01/09 07/01/09 11/01/09 15/01/09 19/01/09 Daily current accounts Deposit facility Reserve requirements

EUR billions
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Source: ECB.

Decline in key interest rates by 325 bp in 7 months

Main refinancing operations %
6

Marginal lending facility

Deposit facility

Eonia (monhtly average)

6 %

0
Au g0 O 7 ct -0 D 7 ec -0 Fe 7 b0 Ap 8 r-0 Ju 8 n0 Au 8 g0 O 8 ct -0 D 8 ec -0 Fe 8 b0 Ap 9 r-0 Ju 9 n0 Au 9 g0 O 9 ct -0 D 9 ec -0 Fe 9 b1 Ap 0 r-1 Ju 0 n1 Au 0 g1 O 0 ct -1 D 0 ec -1 Fe 0 b1 Ap 1 r-1 Ju 1 n1 Au 1 g11

Source: ECB. Last observation: August 2011, monthly averages of daily observations.

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%
10

0 J a n -0 7 M a r-0 7 M a y -0 7 J u l-0 7 S e p -0 7 N o v -0 7 J a n -0 8 M a r-0 8 M a y -0 8 J u l-0 8 S e p -0 8 N o v -0 8 J a n -0 9 M a r-0 9 M a y -0 9 J u l-0 9 S e p -0 9 N o v -0 9 J a n -1 0 M a r-1 0 M a y -1 0 J u l-1 0 S e p -1 0 N o v -1 0 J a n -1 1 M a r-1 1 M a y -1 1 J u l-1 1 0 1 2 3 4 5 6 7 8 9 10

Small loans to NFCs Consumer credit

Source: ECB and ECB calculations. Last observation: July 2011

Short-term

(floating rate and up to 1 year)

Large loans to NFCs Other lending Loans for house pruchase Eonia (monhtly average) %
% 10

affected loans-rates, too!

0 J a n -0 7 M a r-0 7 M a y -0 7 J u l-0 7 S e p -0 7 N o v -0 7 J a n -0 8 M a r-0 8 M a y -0 8 J u l-0 8 S e p -0 8 N o v -0 8 J a n -0 9 M a r-0 9 M a y -0 9 J u l-0 9 S e p -0 9 N o v -0 9 J a n -1 0 M a r-1 0 M a y -1 0 J u l-1 0 S e p -1 0 N o v -1 0 J a n -1 1 M a r-1 1 M a y -1 1 J u l-1 1 0 1

Small loans to NFCs Loans for house purchase (over 5 and up to 10 years) Consumer credit Eonia (monhtly average) Large loans to NFCs Loans for house purchase (over 10 years) Other lending

Long-term
(over 5 years)

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10 %

Further responses enhanced credit support

ECBs enhanced credit support consisted of mainly bank-based measures to support the flow of credit beyond standard interest rate channel
Fixed-rate full allotment Expansion of collateral Longer-term liquidity provision Liquidity provision in foreign currencies Financial market support through purchases of covered bonds

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Temporary improvements
Against background of improved money market conditions ECB introduced exit strategy from non-standard measures, as they were temporary by nature
Non-continuation of purchases of covered bonds Partly withdrawal of liquidity provision in foreign currency Non-continuation of long-term liquidity provision

No pre-determined sequence between the exit from nonstandard measures and interest rate action Assessment of risks to price stability primary criterion
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5-year sovereign CDS spreads

bp
4500 4000 3500 3000 2500 2000 1500 1000 500 0 May-07 May-08 May-09 May-10 May-11 Mar-07 Nov-07 Mar-08 Nov-08 Mar-09 Nov-09 Mar-10 Nov-10 Mar-11 Jul-07 Jul-08 Jul-09 Jul-10 Jan-07 Jan-08 Jan-09 Jan-10 Sep-07 Sep-08 Sep-09 Sep-10 Jan-11 Jul-11 Sep-11

DE

FR

IT

ES

IE

PT

GR
4500 4000 3500 3000 2500 2000 1500 1000 500 0

bp

Source: Bloomberg. Last observation: 14 September 2011, daily observations.

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ECBs response to the sovereign debt crisis

ECB introduced the Securities Markets Programme [SMP] to safeguard the well-functioning of the transmission process by conducting interventions in euro area debt securities markets.

Purchases ensure depth and liquidity in dysfunctional securities markets and are conducted on secondary markets only.

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ECBs response to the sovereign debt crisis

ECB re-introduced some non-standard measures that had been phased-out earlier.
Fixed-rate full allotment in 3M refinancing operations Temporary 6M refinancing operations Fixed-rate full allotment in USD (new)

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Literature

Monthly Bulletin The ECBs monetary policy stance during the financial crisis (January 2010) The ECBs response to the financial crisis (October 2010) Asset price bubbles and monetary policy revisited (November 2010)

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Literature

The Monetary Policy of the ECB

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Literature

The European Central Bank, the Eurosystem, the European System of Central Banks

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Literature

Price Stability: Why is it important for you?

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Monetary policy of the ECB, its concepts and tools

Frankfurt am Main, 20 September 2011

Markus A. Schmidt Directorate Monetary Policy

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