Monetary policy

The primary objective of the Eurosystem, whereof Banco de Portugal is an integral part, is to maintain price stability, thus protecting the purchasing power of the euro, as stipulated by the Treaty establishing the European Community.

Without prejudice to the objective of price stability, the Eurosystem shall support the general economic policies in the Community with a view to contributing to the achievement of the Community objectives, which include a high level of employment and sustainable and non-inflationary growth.

This primary objective reflects a broad consensus among economists and policy makers that ensuring price stability is the most important contribution that monetary policy can make to achieving sustained economic growth. 

The ECB’s monetary policy strategy

In order to maintain price stability, the European Central Bank (ECB) has adopted a monetary policy strategy that includes an accurate definition of that objective. In 1998 the Governing Council of the ECB announced the following quantitative definition: “Price stability shall be defined as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%. Price stability is to be maintained over the medium term.” Following an evaluation of the monetary policy strategy in 2003, the Governing Council confirmed this definition. At the same time, the Governing Council agreed that in the pursuit of price stability it will aim to maintain inflation rates below, but close to, 2% over the medium term. This clarification underlines the ECB’s commitment to provide a sufficient safety margin to guard against the risks of deflation. It also addresses the issue of the possible presence of a measurement bias in the HICP and the implications of inflation differentials within the euro area.

The statement that “price stability is to be maintained over the medium term” reflects the need for monetary policy to have a forward-looking orientation. Furthermore, it acknowledges the xistence of short-term price volatility that cannot be controlled by monetary policy.
The ECB’s monetary policy strategy comprises a quantitative definition of price stability and provides a framework which ensures that the Governing Council assesses all the relevant information needed to take monetary policy decisions. The ECB’s approach to organising, evaluating and cross-checking information relevant for assessing the risks to price stability is based on two complementary analytical perspectives on the determination of price developments, referred to as the “two pillars”. This approach was confirmed and further clarified by the Governing Council in 2003.

The first perspective, referred to as the “economic analysis”, is aimed at identifying the short to medium-term risks to price stability, with a focus on real activity and financial conditions in the economy. It takes account of the fact that price developments over those horizons are influenced largely by the interplay of supply and demand in the goods, services and factor markets. The ECB/Eurosystem’s regular macroeconomic projection exercises are part of this “economic analysis”.

The second perspective, referred to as the “monetary analysis”, is aimed at assessing medium to long-term inflation trends, taking into account the close link between money and prices over longer-term horizons. The monetary analysis mainly serves as a means of cross-checking, from a medium to long-term perspective, the short to medium-term indications stemming from the economic analysis. 

Transmission mechanism of monetary policy

The central bank, as the sole issuer of banknotes and sole provider of bank reserves, is the monopoly supplier of the monetary base. Credit institutions need base money  in order to meet the public demand for currency, to clear interbank balances (cheques, transfers, etc.) and to fulfil minimum reserve requirements. The base money can be traded by the credit institutions within the interbank money market: those having excess funds lend to those who have a shortage of funds, at a given interest rate. If the amount of base money available in the money market is insufficient to meet the needs – liquidity shortage – the interbank money market interest rates naturally tend to rise. On the contrary, if the amount of base money available in the money market is abundant – excess liquidity – interest rates tend to decrease.

By virtue of this monopoly, the central bank sets the conditions at which banks borrow from it. Therefore it can also influence the conditions at which banks trade with each other in the money market. By intervening in the money market, the Eurosystem aims at regulating liquidity conditions, so that interest rates stand at levels deemed consistent with the price stability objective.

The Eurosystem can intervene in the money market at rates set by itself – accordingly called official Eurosystem rates –, either to inject liquidity into the money market, in the event of liquidity shortage, or to absorb excess liquidity. To that effect, the Eurosystem uses two types of instruments: standing facilities and open market operations, on the basis of a minimum reserve system, to which credit institutions are subject.

A change in money market interest rates induced by the central bank and expectations about future developments in interest rates set in motion a number of mechanisms and actions by economic agents, ultimately influencing developments in economic variables such as output or prices. This complex process is known as the monetary policy transmission mechanism. This mechanism, together with other aspects of the ECB’s monetary policy, is described in detail in the book entitled “The monetary policy of the ECB”.