What is it and how does it work?
The Eurosystem – composed of the European Central Bank (ECB) and the euro area national central banks (NCBs), including the Banco de Portugal – is the authority responsible for defining and implementing the euro area monetary policy.
The primary objective of the euro area monetary policy is to maintain price stability, thus protecting the purchasing power of the euro.
Without prejudice to the objective of price stability, the Eurosystem shall support the general economic policies in the European Union (EU) with a view to contributing to the achievement of the EU objectives, which include a high level of employment, balanced economic growth, and a high level of protection and improvement of the quality of the environment.
The Eurosystem’s monetary policy is:
- Defined by the Governing Council of the ECB;
- Implemented by the Executive Board of the ECB, in accordance with the guidelines and decisions of the Governing Council;
- Executed in a decentralised manner by the NCBs, including the Banco de Portugal, in accordance with the instructions from the Executive Board.
The Governing Council comprises the members of the Executive Board of the ECB and the governors of the NCBs of the Member States which have adopted the euro, including the Governor of the Banco de Portugal.
The Executive Board consists of the President and the Vice-President of the ECB and four other members appointed by the European Council.
Price stability contributes to sustainable growth, economic welfare and job creation, by:
- Reducing uncertainty as regards general price developments, allowing households and corporations to make better consumption and investment decisions;
- Reducing inflation risk premia in interest rates (i.e. additional compensation), contributing to the efficiency of capital markets when allocating resources and increasing incentives to invest;
- Avoiding unnecessary hedging activities, reducing the probability of households and corporations diverting resources in order to protect themselves against inflation or deflation;
- Reducing distortion impacts on tax and social security systems;
- Increasing the benefits of holding cash;
- Preventing an arbitrary distribution of wealth and income;
- Contributing to financial stability.
The Governing Council considers that price stability is best maintained with a symmetric 2% inflation target over the medium term.
How is inflation measured?
In the euro area, inflation is measured by the change in the harmonised index of consumer prices (HICP) and is calculated by Eurostat. The HICP reflects average household expenditure in the euro area for a basket of goods and services.
Why over the medium term?
The medium-term orientation acknowledges the existence of short-term price volatility that cannot be controlled by monetary policy, as well as lags and uncertainty in the transmission of monetary policy to the economy and to inflation. It allows the Governing Council to respond in a flexible manner, depending on the deviation of inflation from the target, and to cater for other considerations relevant to the pursuit of price stability.
Why a 2% inflation target?
In order to provide monetary policy with space for interest rate cuts in the event of adverse developments and a sufficient safety margin against deflation, i.e. against the broad-based decline in prices, deemed harmful to the welfare of consumers. This margin is also important to accommodate inflation differentials within the euro area, as well as possible biases when calculating the HICP.
The objective of maintaining price stability is carried out conventionally through interest rate control. Thus, the Governing Council defines the official interest rates of the Eurosystem, i.e. the interest rates at which the Eurosystem provides liquidity to, and absorbs liquidity from, the banking system.
For the purpose, the instruments used by the Eurosystem are open market operations, standing facilities, and minimum reserve requirements.
Monetary policy decisions made by the Governing Council are based on an integrated assessment of the outlook and risks to price stability. This assessment builds on two interdependent analyses: the economic analysis and the monetary and financial analysis.
The economic analysis focuses on real and nominal economic developments and is namely based on short-term developments in economic growth, employment and inflation, an assessment of shocks hitting the euro area and projections of key macroeconomic variables over a medium-term horizon.
The monetary and financial analysis examines monetary and financial indicators, with a focus on the operation of the monetary policy transmission mechanism and the possible risks to medium-term price stability from financial imbalances and monetary factors.
Economic analysis and monetary analysis
Monetary policy decisions made by the Governing Council are based on an assessment of risks to price stability. This assessment is based on two complementary pillars: economic analysis and monetary analysis.
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, including the preparation of economic projections.
The monetary analysis is aimed at assessing medium to long-term inflation trends, taking into account the close link between the quantity of money and prices over longer-term horizons. Monetary analysis offers a complement, from a medium to long-term perspective, to the short and medium-term indications provided by economic analysis.
The process whereby monetary policy decisions affect the economy in general and the price level in particular is known as “monetary policy transmission mechanism”. The individual links whereby monetary policy impulses are processed are known as transmission channels.
The chain of cause and effect linking monetary policy decisions with the price level starts with a change in the official interest rates or expectations about their future developments.
The dynamic process outlined above involves a number of different mechanisms and actions by economic agents at the various stages of the process. As a result, monetary policy action usually takes some time to affect price developments. Furthermore, the size and strength of the different effects may vary according to the state of the economy and developments in agents’ expectations, making their impact difficult to estimate.