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 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 and sustainable and non-inflationary growth.
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 national central banks, including 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 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 allocate 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 ECB’s Governing Council has defined price stability as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2% over the medium term. In 2003, the Governing Council clarified that, in the pursuit of price stability, it aims to maintain the inflation rate below, but close to, 2% over the medium term.
How is inflation measured?
In the euro area, inflation is measured by the change in the HICP and is calculated by Eurostat. The HICP reflects average household expenditure in the euro area for a basket of products.
Why over the medium term?
The statement that price stability is to be maintained over the medium term reflects the monetary policy need for a forward-looking orientation. Furthermore, it acknowledges the existence of short-term price volatility that cannot be controlled by monetary policy.
Why at a level below, but close to, 2%?
In order to provide 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.
When making monetary policy decisions, the Governing Council takes into account:
- The quantitative definition of price stability;
- The economic analysis and the monetary analysis of risks to price stability.
These are the two components of the ECB’s ‘monetary policy strategy’, as it is known.
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.