The European Central Bank (ECB) was formed in 1998 ahead of the formal introduction of European Monetary Union and the Euro. The Euro came into operation at the beginning of 1999 in virtual form with notes and coins introduced at the beginning of 2002. The ECB is the central bank to all countries participating in the monetary union. From 11 countries at the start, this has now been expanded to 19 and the national central banks make up the Eurosystem.
The ECB is responsible for four key areas:
- Defining and implementing monetary policy
- Conducting foreign exchange operations
- Managing Euro-area currency reserves
- Promoting the smooth operation of payment systems
Is the ECB Independent?
The ECB has full operation control of monetary policy in line with the Federal Reserve and Bank of England. Crucially, however, the ECB also has independence to define price stability. In the European Union Treaty, the prime objective for the ECB is to achieve price stability, as defined by the bank itself.
There are secondary objectives of contributing to the achievement of the objectives of the union, which include full employment and balanced growth.
Crucially, there is no provision for the inflation target to be changed by governments, although it would be theoretically possible to make a Treaty change, this is extremely unlikely. The ECB is therefore more independent than the Federal Reserve and the most independent of all major global central banks in terms of inflation targeting.
The ECB President testifies to the European parliament on a regular basis to explain the bank’s actions and present updated assessments of economic activity.
European Central Bank Objectives
The ECB has defined price stability as achieving a rate of consumer inflation below, but close to 2% per annum.
The bank also has the goal of avoiding excessive fluctuations in output and employment, but the primary objective is the achievement of price stability.
ECB Executive Board
The ECB Executive Board is the governing body and guides the operation of the ECB to promote the goals and fulfil its responsibilities.
The Executive Board is comprised of the President, Vice President and four other members that are appointed by the European Council.
Members of the Executive Board are appointed based on recommendations provided by the ECB’s Governing Council and European Parliament.
The Executive Board prepares Governing Council meetings and implements monetary policy in accordance with decisions taken by the Council.
Monetary Policy Operation
The European Central Bank adjusts monetary policy in order to achieve its target of price stability. This can be achieved by adjusting the level of interest rates by changing the target for the main ECB interest rates.
More recently, the ECB has also operated monetary policy by engaging in non-standard operations. These include quantitative easing through the purchase of government bonds, which inflate the balance sheet.
In June 2016, this policy was enhanced by the decision to include corporate bonds. Outright Monetary Transactions, which involve secondary bond purchases, was announced in 2012, although this policy has so far not been used.
Longer-Term Financing Operations
The European Central Bank provides regular short-term liquidity operations to provide short-term credit to the banking sector. As part of its non-standard policy operations, the bank also provides long-term refinancing operations (TLTRO) through the provision of long-term funds to the banking sector at very attractive interest rates. These are aimed at boosting liquidity and lending with the amount that can be borrowed dependent on the amount of loans provided to the corporate and household sector. The TLTRO programme started in 2014 and a new TLTRO2 version was launched in 2016.
ECB Benchmark Interest Rates
The ECB targets three interest rates:
- The deposit rate – the rate which banks may use to make overnight deposits with the Eurosystem.
- The refinance rate – which provides the bulk of liquidity to the banking system
- The marginal lending facility – which offers overnight credit to Eurosystem banks
ECB Governing Council
Any changes in monetary policy are agreed through the Governing Council, which meets eight times per year to formally discuss monetary policy, although it also meets at other times to discuss other matters.
The Governing Council is comprised of the Executive Board and the heads of the 19 national central banks, which are members of the Euro area. All national bank heads take part in the policy discussion.
There is a rotation system of voting on policy decisions; representatives of four of the five largest economies vote at each policy meeting together with 11 of the 14 other representatives. Overall, there should be 21 voting members at each Governing Council meeting.
Following the meeting, the policy decision is announced with any changes to the main interest rates and any other changes in monetary policy. Every quarter, the ECB issues updated forecasts for growth and inflation.
European Central Bank Press Conference
Following the ECB Governing Council meetings, bank President Draghi holds a regular press conference. This is comprised of a prepared statement where he outlines the economic background to the policy decisions and makes general comments on policy direction and currency matters. The prepared statement is followed by a Q&A session. The press conference is often more important than the rate decision in terms of market reaction, especially if there are no changes made to interest rates.
ECB Monetary Policy Meeting Accounts (minutes)
The minutes of the meeting are usually released four weeks after the meetings have taken place. The minutes provide a detailed record of the discussions that took place and describe the thoughts of the Council.
The minutes can be useful in determining potential future policy actions, although they tend to add little to the statement released by the resident following the Council meetings, especially as they tend to be rather general and do little to reveal splits between members.
ECB Member Speeches
Members of the ECB Executive Board and Governing Council often make speeches during their time in office. These are important in setting out their thoughts on the economy and potential trends in interest rates, especially as prepared comments are often followed by a Q&A session.
These remarks can be significant in moving markets with the speeches from the ECB President generally much more important than other members, especially when the President is looking to signal a change in policy direction or make a specific point over market trends.
The ECB produces a number of economic data releases relating to credit, money and the balance of payments, although they are not the most important data releases with most timely and market-moving data provided by Eurostat.
The ECB has the power to intervene in the currency markets and either buy or sell the Euro if it feels there is serious malfunction in the market operations or that the exchange rate is substantially out of line with economic fundamentals. Intervention is rarely used, but can have a very substantial market impact when deployed.
Bank Stress Tests
The ECB runs stress tests in conjunction with the European Banking Association (EBA) in order to test the resilience of commercial banks and key financial institutions. Various simulations are used to illustrate a severe and extreme financial shock to the economy such as a deep recession, severe decline in equity markets or a crash in the housing sector. Simulations then determine the extent to which bank capital is depleted and whether the banks would remain solvent in extreme circumstances. If the banks are deemed to be vulnerable, they will be encouraged, through the relevant national central banks, to strengthen their capital position.
The ECB’s International Responsibility
The ECB has strong responsibility to co-operate with the national central banks within the Eurosystem. The ECB provides credit to other central banks in return for collateral. The ECB can also provide Emergency Liquidity Assistance (ELA) to institutions that are solvent, but facing short-term liquidity difficulties. ELA funds are provided by national central banks under ECB governance.
The ECB also needs to ensure there is sufficient liquidity in the financial system and will co-operate with other global central banks to ensure liquidity is maintained. There will also be frequent discussions with heads of other global central banks to boost co-operation, especially when financial markets are extremely volatile.