The Monetary of European Central Bank

The European Central Bank (ECB) was established in June 1998, as the core of European System of Central Banks (ESCB), ECB formally centralized the European monetary policies since January 1999. This new monetary authority is quite different from any traditional sovereign central banks, for its operational independence and its independence from political interference are guaranteed by the European Union Treaty. Besides, the supranational organizational attribution make it has the only responsibility for monetary policy in the whole euro zone, which now consist of eighteen member states of the European Union.

During the sixteen years since its establishment, ECB has confronted several economic fluctuations, especially the global financial crisis in 2008 and sovereign debt crisis since 2010. The ECB plays an important role in the conduct of its main strategies and tools of monetary policy to stabilise the euro currency in the crisis. The strategies of ECB The monetary policy strategy of ECB is price stability-oriented (Bordes, Christian and Clerc, 2007). The Maastricht Treaty defined that the ECB’s ultimate objective is price stability.

The ECB’s monetary policy strategies consist of three key components: a quantitative definition of price stability, a prominent role for money in the assessment of risks to price stability, and a broadly based assessment of the outlook for price developments (Gradinaru, Cristian, 2009). 1. Price Stability Since the birth of euro in 1999, the ESCB has set up its primary task for maintaining price stability.

According to the Maastricht Treaty, the primary objective of ECB is to keep price stability in the entire euro area. And other objectives to be pursued by the ECB, in particular those more involved in output and high employment in the euro economy, should only be addressed if price stability is maintained(Clausen and Donges,2001) (Aksoy, DeGrauwe and Dewachter, 2002). Some researchers (Grauwe and Paul De, 2002) suggest that the Treaty uses the word ‘primary’ but not ‘sole’ objective should be note, as is sometimes erroneously concluded.

So, according to the Treaty the ECB should also pursue other objectives like sustaining business cycle, provided this does not endanger price stability. But some other experts took a different view of point, Weber (2011) emphasized that monetary policy and its tools must remain focused on price stability and should not be overburdened with other objectives. Since adopting extra objectives as an additional, such as financial stability, independent monetary policy objective runs the risk of arousing unrealistic expectations about the effectiveness of monetary policy tools. In addition, the definition of the primary objective was specified more precisely by the ECB (1998) to be ”a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%”, which is ‘to be maintained over the medium term’ (Clausen and Donges, 2001).

(Aksoy, DeGrauwe and Dewachter, 2002) (Fendel and Frenkel, 2006). It is no deniable that the HICP has many advantages, not only because its availability, but also it is the only harmonized indices calculated for the whole euro zone. This guarantees the comparability of prices of the entire euro area. Also, the HICP are regarded as a credible price-level changes measurement and it is available on a monthly basis (Bordes, Christian and Clerc, 2007).

Hence, Clausen and Donges (2001) believe that it is a precious contribution to employment creation and economic development in the whole euro zone which can be expected from monetary policy. However, there are also some drawbacks of the HICP. As Bordes, Christian and Clerc (2007) stated, HICP can be refined through more frequent revisions of the weights used at national level. Besides, there are only 5 out of 12 states updates their weights every year. And the margin of error exists in the price measurement in the euro zone. Some critics would prefer to replacing HICP with core inflation rate, Analysis given by Wyplosz (2001) argue that the band of inflation target of EBC is too low and too narrow, they suggested adopting range of 1% to 4% instead.

In a series of papers, Svensson (2000) indicated that the definition of European price stability is obscure and asymmetrical, which means it is less effective as a target for anchoring inflation expectations. And Grauwe and Paul De (2002) recommended smaller range of 2% to 3% a year. Furthermore, if the inflation rate of euro zone is successfully maintained within 0–2 percent by the ECB, it is inevitable that the inflation rate of some euro countries will drop below 0 percent, since the target inflation rate is an average of national inflation rates, and deflationary forces in certain countries are difficult to control (Grauwe and Paul De, 2002).

Moreover, ECB’s low inflation target makes a prejudice against the force that acting rapidly to react economic recessionary. The article of Grauwe and Paul De (2002) indicated that in 2001 when the ECB waited to reduce the interest rate owing to the inflation rate 2% threshold. But the US Federal Reserve acting rapidly since it does not have such a low inflation target. 2. Two-pillar Strategy In addition to the price stability, the strategy consists of two- pillars with which the prospective assessment of the economy is base on.

The First pillar is monetary analysis – a prominent role to the quantity of money in circulation. The broad monetary aggregate M3 has been chosen for which a quantitative ‘reference value’ is announced each year, on the basis of this aggregate is a good indicator for future price developments( Fendel and Frenkel,2006)(Clausen and Donges, 2001). As Grauwe and Paul De (2002) indicated, it has resulted in the formulation of a reference value for the growth rate of money (M3) of 4. 5 per cent that should not be exceeded.

However, it is hard to base the strategy on monetary aggregates if these special effects occur over longer periods. If so, this pillar seems ineffective, as it has been the case for several economies in the past, which led them to formulate direct inflation- targeting strategies (Fendel and Frenkel, 2006). The second pillar is economic analysis, which consists of an analysis of a wide range of other economic and financial variables that usually affect price changes (Fendel and Frenkel, 2006). Model-based forecasts and a variety of other indicators are included in this broad-based analysis of the prospective for inflation.

The basket of indicators contains bond prices, the exchange rate, oil prices, the yield curve, unit labor costs, and the degree of capacity utilization in the economy. The ECB emphasized that the second pillar is not simply equal to an inflation forecast. In December 2000, after having been exposed to quite pressure, it published the first internal forecast of HICP growth and real GDP growth for a two-year horizon. These forecasts constitute conditional forecasts as they are conducted on the assumption of unchanged short term interest rates and, inter alia, constant exchange rates (Clausen and Donges, 2001).

At the very start, criticism made to the ECB for the formulation of the two pillars, due to such kind of strategy may result in contradictions and inconsistencies, and be difficult to be communicated to the markets (Fendel and Frenkel, 2006). The tool of ECB The most basic instrument applied by ECB is interest rate. Goodhart (2006) proposed that, since there can only be one sole nominal interest rate in an integrated euro currency union. This entails the disadvantage that regions with faster in? ation, often the country who enjoy stronger growth, will face lower ‘real’ interest rates than those with lower in? ation.

While this is inevitable, it is the reverse of what would be desirable. Therefore, Hugo Dixon (2013) pointed out, setting interest rates at a level that which suitable to the euro zone on average had the effect of inflating the Irish and Spanish property bubbles while pushing wages up, thus their economies became uncompetitive. And the damage was devastating when the bubbles burst. Hugo Dixon (2013) emphasized that the European Central Bank keeping interest rates at the current low level for an ”extended period” is correct for the average euro zone.

The even looser monetary policy would benefit the weaker countries. Though, Germany may already need tighter monetary policy. If the ”extended period” of low interest rates goes on for years, it could experience a boom. Many observers (Hugo Dixon, 2013) take one-size-fits-all interest rates as one of the zone’s design defects, about which nothing can be done. Others advocate policies — like full fiscal union — that are not going to be adopted and would not really hit the spot, even if they were. In addition, the operational framework of the Eurosystem consists of the following set of instruments: open market operations, standing facilities, minimum reserve requirements for credit institutions.

Among them, Open market operations play an important role in controlling interest rates, managing the liquidity situation in the market and signaling the monetary policy stance. There are five types of financial instrument are available to the Eurosystem for its open market operations. The most important instrument is the reverse transaction, which may be conducted in the form of a repurchase agreement or as a collateralised loan.

The Eurosystem may also make use of outright transactions, issuance of debt certificates, foreign exchange swaps and collection of fixed-term deposits. (Ejerskov et al. ,2008) Conclusion In short, due to the ECB’s strategy focuses on both aspects of monetary stability, this means that it can be supposed to a hybrid strategy –an Ireland rule – aimed at anchoring medium term inflation expectations, while simultaneously seeking to reduce long term price-level uncertainty.

As Jaeger (2002) described, it can be seen as ‘a modified version of an inflation target, where the central bank avoids announcing a precise value or range for the medium-term inflation rate, while using an explicit nominal anchor (the reference value for M3 growth) to shape long-term inflation expectations’ (Bordes, Christian and Clerc, 2007).

As evidenced by the literature review, it shows that the ECB has been successful in the conduct of monetary policy and used its main strategies and tools to stabilise the euro currency in the past, although there are still some problems such as countries in the euro area sometimes have different inflation rates and business cycles, we believe that more accurate monetary policy decisions can be made to solve the problems. Bibliography Aksoy,Y. , De Grauwe P. , Dewachter H. (2002),Do asymmetries matter for European monetarypolicy?

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The Little Currency That Couldn’t, Foreign Affairs, Jan/Feb 2012, Vol 91(1), pp. 105-116. Fendel R. M. , Frenkel M. R. (2006) Five Years of Single European Monetary Policy in Practice: Is the ECB Rule- Based? Contemporary Economic Policy, 2006, Vol. 24 (1), pp. 106-115 Gerlach S. , Svensson L. E. O (2003) Money and inflation in the euro area: A case for monetary indicators? Journal of Monetary Economics, 2003, Vol. 50(8), pp. 1649-1672 Goodhart C. A. E. (2006), The ECB and the Conduct of Monetary Policy: Goodhart’s Law and Lessons from the Euro Area, JCMS 2006 Volume 44.

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