Implementing monetary policy in the euro area
Ms Sirkka Hämäläinen, Member of the Executive Board European Credit Expansion Forum: New Currents in Financing Marriott Hotel, Frankfurt 26 March 2002.
I would like to start by thanking the organisers for inviting me to speak at this European corporate credit conference. Since the launch of the single currency in 1999, the advancement and deepening of the corporate credit market has been one of the most positive developments in the euro area financial markets. We at the European Central Bank have followed this development with satisfaction, since it has not only highlighted the many benefits we are reaping from having the single currency, but also reflected the important processes of financial innovation, disintermediation and securitisation that are necessary in order to fully benefit from the single market and the single currency.
The topics covered by this conference reflect the facts that the monetary policy transmission mechanism is undergoing continuous change and the Eurosystem is not implementing monetary policy in a static financial environment. At the ECB, we are continuously monitoring and analysing the impact of structural changes taking place in the euro area financial markets on monetary policy formulation and its implementation in particular.
The implementation of monetary policy is an important part of a route, which leads from the primary objective of price stability to the ultimate effects of the monetary policy decisions. Here I will call this route the "monetary policy chain".
Like any other chain, the monetary policy chain should also have equally strong and tightly connected links. All the links – objective, strategy, decisions, implementation and transmission – are vitally important, since the chain as a whole is only as strong as its weakest link.
Let me first briefly recall the primary objective and the strategy of monetary policy, the first links in the monetary policy chain.
The Treaty establishing the European Community assigned to the ECB the maintenance of price stability in the euro area as its primary objective and unambiguous mandate. Rooted in the long-standing experience of the participating national central banks, there exists the conviction that it is with the credible and lasting maintenance of price stability that the ECB can best enhance the welfare of euro area citizens.
The Governing Council of the ECB – the body collectively responsible for monetary policy decisions – defined price stability as "a year-on-year increase in the Harmonised Index of Consumer Prices for the euro area of below 2%". The Governing Council also stated that price stability "is to be maintained over the medium term", meaning that in the short term, factors other than monetary policy can cause transitory deviations from this objective. The announcement of a numerical definition of price stability has been devised to enhance clarity, anchor expectations and offer a yardstick against which the ECB can be held accountable.
Monetary policy strategy and decisions
The complexity of the interaction between monetary policy and the economy requires the preparation, discussion and presentation of policy decisions to be placed in a coherent framework. This is the task of the monetary policy strategy, which is designed both to create a consistent structure for the discussions in the Governing Council and to provide an efficient vehicle for communicating with the public.
It is widely acknowledged that central banks necessarily operate in an environment characterised by substantial uncertainty, not only with regard to current and future developments, but also the actual functioning of the economy. Although this is particularly true in the context of the newly established euro area, we can say that the shift from a regime with 12 separate monetary policies to one with a single policy has been smoother than expected.
The ECB designed a two-pillared strategy, with the objective of capturing and providing in a well-structured manner all the relevant pieces of information on the euro area economy for the assessment of the Governing Council.
The first pillar of the monetary policy strategy recognises that inflation is ultimately a monetary phenomenon. The prominent role given to money allows advantage to be taken of the stability of the relationship between broad monetary aggregates and the price level in the euro area.
Under the second pillar, the ECB regularly monitors a broad set of mainly non-monetary variables in order to assess the risks and prospects related to future price developments. These variables include among others wages, labour costs, fiscal policy statistics, and financial market indicators like stock prices, exchange rates and bond yields. Within the framework of the second pillar, the Eurosystem staff also produces macroeconomic projections.
Using the monetary policy strategy as a framework, the Governing Council assesses the monetary policy stance, as a rule, at its first meeting of the month. However, if warranted by exceptional circumstances, the Governing Council can decide to change the key ECB interest rates at any time, regardless of previously scheduled meetings, as was the case following the terrorist attacks in the United States on 11 September last year.
Monetary policy implementation
Today, most major central banks around the world implement monetary policy by seeking to control short-term money market interest rates. This is the case at the ECB too. There are many natural reasons for this. In particular, the expected levels of short-term interest rates are the basis for the determination of the longer-term interest rates and ultimately the whole yield curve. The longer rates, in particular, are very important for the transmission of monetary policy. It is crucial that short-term interest rates reflect monetary policy decisions as precisely and in as stable a manner as possible. Excessive volatility of short rates would blur the signalling and the transmission of the monetary policy stance.
Different methods may be used by central bankers to influence interest rates. In the case of the ECB, the choice of a particular framework is based on several clearly expressed principles.
The operational framework of the Eurosystem is based on the general principles laid down in the Treaty on European Union, which states that the Eurosystem "shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources". In addition to the principles set out in the Treaty, the operational framework aims to follow other important principles agreed upon by the Governing Council.
One of the most important principles is that of operational efficiency, which can be defined in broad terms as the capacity of the operational framework to enable monetary policy decisions to feed through to short-term money market rates as precisely and as quickly as possible. Operational efficiency requires transparency. Transparency ensures that market participants can correctly interpret and understand the intentions behind central bank operations. Today, everything that central banks say and do is immediately scrutinised by the markets and the risk of sending unintended monetary policy signals is not inconsiderable. In order to minimise this risk, the European Central Bank publishes detailed data on liquidity conditions and forecasts through the wire services on a daily basis, and reviews the operational decisions in its Monthly Bulletin.
In addition to efficiency and transparency, the principles of equal treatment and the decentralised execution of monetary policy have been identified as crucial for the euro area which comprises 12 member countries. This means that – unlike the situation for other major central banks – a high number of potential counterparties (around 2,500 credit institutions) can take part in Eurosystem open market operations. When participating in these operations, the credit institutions conduct the actual transactions via their "local" national central banks after the decisions by the Executive Board of the ECB and under ECB co-ordination.
Unlike monetary policy decisions, which usually attract much media attention, the implementation of monetary policy is actively followed by only a relatively small number of professionals. As the practical implementation of monetary policy decisions is an important link in the monetary policy chain, we at the ECB lend much weight to the ways in which this is done. Let me be more precise about this link.
The banking system needs liquidity from the central bank. These liquidity needs are for a large part exogenous to the banking system and arise from banknotes in circulation, government deposits with the Eurosystem and requirements for minimum reserves that, according to our regulations, the credit institutions have to deposit with the Eurosystem central banks. Given its monopoly to supply liquidity to the banking system, the ECB exerts a dominant influence on the conditions in the money market and can thereby steer money market interest rates. When the monetary policy strategy gives guidance on which money market interest rate level is required to maintain price stability over the medium term, the operational framework of the Eurosystem, and the way in which it is used, determine how this interest rate level is achieved.
The main monetary policy signal is given by the Governing Council, when it decides on the interest rate level in the Eurosystem's weekly liquidity tenders. Weekly tenders are conducted as variable rate tenders with a minimum bid rate and they are the main channel for managing the liquidity conditions in the money market. At the same time, the Governing Council decides on the interest rates on the so-called standing facilities. These rates are the marginal lending rate at which the credit institutions can borrow unlimited amounts from the Eurosystem on a daily basis against collateral, and the deposit rate at which the credit institutions can deposit unlimited amounts with the Eurosystem on a daily basis. The standing facilities guarantee the flexibility of the liquidity supply in case of unexpected developments, and the marginal lending rate and deposit rate form the corridor within which the shortest money market interest rates fluctuate. Currently, this corridor is ±1 percentage point around the minimum bid rate of 3.25%. If there are unexpected liquidity fluctuations, the ECB can intervene promptly using fine-tuning operations to provide or absorb liquidity at any time between the regular tender operations, thus preventing excessive volatility in the overnight and short-term money market rates.
As I said earlier, the Executive Board of the ECB makes decisions on the implementation of monetary policy in accordance with the decisions made and guidelines laid down by the Governing Council. In practice, this means inter alia that the decisions on allotment volumes in the weekly tenders to the euro area as a whole are prepared by the ECB's liquidity management function and taken by the Executive Board. The management of liquidity conditions in the money market requires continuous real-time monitoring, a great degree of precision and promptness, and the continuous involvement of all the central banks of the Eurosystem. The actual execution of tenders takes place through the national central banks.
I would like to stress that the Eurosystem's operational framework is, indeed, very market-oriented. This is reflected in the facts that the Eurosystem pays interest on required minimum reserves, relies heavily on auction procedures in supplying liquidity and accepts a wide range of assets, both public and private, as collateral in its monetary policy operations. We can also say that our operational framework is efficient and has been used in an efficient way. In spite of some problems in forecasting the liquidity effects of the government deposits with some participating national central banks and lately of the banknotes and coins in circulation caused by the euro cash changeover, we have been able to assess the liquidity needs rather accurately and thus to allot appropriate amounts of liquidity in the weekly tenders. Developments in the overnight rate have been stable, more stable than in almost any other money market in the world. We have resorted to fine-tuning operations only six times in over more than three years.
The allotment decisions in the weekly tenders are normally anticipated by the market participants to a great extent. Based on our transparency principle, we communicate to the markets information on prevailing and expected liquidity conditions in the banking system. This allows sophisticated counterparties to anticipate the allotment decisions and it minimises unnecessary surprises, which is crucial for avoiding misinterpretations and unintended monetary policy signals.
Metaphorically speaking, the Eurosystem's operational framework functions as if it were an autopilot, which works smoothly under normal circumstances following the instructions given to it. However, as we know, autopilots can be dangerous when something unexpected happens. That is why flexibility and diversity are inherent in our operational framework, allowing the Executive Board to act rapidly if need be. An example of this was the Eurosystem's prompt reaction to the implications of the terrorist attacks on 11 September last year in the euro and the dollar money markets. Another good example was the euro cash changeover which, despite its very exceptional nature, required only two fine-tuning operations.
The money market plays a vital role in the implementation of monetary policy decisions and the efficiency of implementation depends to a great extent on the counterparties and their behaviour. The market orientation of the system not only gives the counterparties more possibilities, but also more responsibility for their actions. We at the ECB rely on our counterparties to behave reasonably and according to their genuine liquidity needs. Here I would like to refer to the cases of underbidding experienced last year, where the speculative behaviour of the counterparties under interest rate cut expectations led to insufficient demand for liquidity in the weekly tenders. The tight liquidity conditions and high interbank overnight rates which resulted from that speculative behaviour improved the understanding in the money market that the banking sector cannot use the tenders collectively as a profit-making channel.
The transmission of monetary policy
The implementation of monetary policy decisions only provides the initial impulse to the process of monetary policy transmission, a process that escapes for the most part the direct control of the central bank. Therefore, let me now briefly focus on the last link in the monetary policy chain that I am describing today, namely the monetary policy transmission mechanism.
In addition to direct effects, the announcement and implementation of monetary policy decisions have indirect effects via expectations about the future course of monetary policy. Inflationary expectations, longer-term interest rates, wage and price setting, as well as asset prices and the exchange rate are affected. These all influence the saving, spending and investment decisions of households and firms, and ultimately the price level. Expectations have a considerable impact on the direct effects of monetary policy decisions, highlighting the importance of the credibility and communication of the central bank.
The monetary transmission mechanism in the euro area has been a subject of considerable interest, both from a policy and an academic viewpoint. Yet, the relevant empirical knowledge is far from comprehensive. This is hardly unique in itself – after all, no central bank operates in an environment of certainty. In the context of the euro area, this uncertainty was originally high owing to the newness of the monetary union, the lack of area-wide statistical data and the not inconsiderable structural differences among the economies and financial structures of the euro area countries. It is, however, gradually diminishing over time.
It is true that some key links in the transmission mechanism, such as the money market, are now common to all euro area countries. However, it is possible that remaining cross-country differences in financial structures, for example in the corporate credit market, may lead to somewhat asymmetric effects of the single monetary policy on the countries forming the euro area. This is one reason why further integration of the euro area financial markets is seen as being necessary.
What we can say for certain about the transmission mechanism is that any monetary policy action takes considerable time to affect the economy and that the precise impact is not easy to estimate. An overview based on a wide range of empirical analyses suggests that a change in the short-term interest rate temporarily affects output, with the main effects occurring after roughly one year. Prices normally react more slowly, after one to two years.
The evidence on the different channels of the transmission mechanism is also building up. In the past, the exchange rate channel used to be important for each of the euro area countries. However, one of the most important changes resulting from the introduction of the single currency was the reduced importance of exchange rate developments and correspondingly the increased importance of the domestic transmission channels, namely the interest rate channel and the credit channel.
In the interest rate channel, interest rates and asset prices play the main role in transmitting monetary policy impulses. When market interest rates adjust to monetary policy decisions, they also affect other financial prices such as those of fixed-income instruments with longer maturities or equities. On the basis of asset price developments, households are likely to adjust their savings and consumption. Moreover, changes in asset prices and interest rates can affect consumers' disposable income and wealth and, thereby, their demand for goods and services and the prices of these.
The credit channel of the transmission mechanism is connected with the supply of credit. Typically, companies and private households have limited possibilities for financing desired purchases and they have to resort to financing mainly from banks for which they need collateral. The precise effects of the transmission of monetary policy impulses via the credit channel depend on the level of interest rates, the financial structure, and sometimes also the general economic environment.
The ongoing shift from bank-based to market-based financing and the further integration of the euro area financial markets can be expected to increase the prominence of the interest rate channel further. The credit market, the market segment that most of you represent, is a key segment in this development.
The financial markets, well-known for their pitiless judgement, have been confirming the credibility of our monetary policy. This is evidenced by the developments in long-term interest rates, which have been in line with our objective of maintaining price stability. We are committed to not putting this significant achievement at risk.
My aim today was to characterise monetary policy as a series of links, which connect the primary objective of price stability with the final effects of monetary policy decisions. I have highlighted one link in particular: the implementation of monetary policy. I am happy to say that monetary policy implementation has been one of our tasks that can be assessed very positively.
It is important to realise that what we do in the Eurosystem affects the markets and, conversely, developments in market structures affect what we do. The ongoing developments in and the further integration of the euro area financial markets will create future challenges for our operational framework and our understanding of the monetary policy transmission mechanism. To keep up with these developments, we have made considerable efforts, among other things, to establish informal and formal channels for communicating with the financial community. I would like to refer here to the example of our Money Market Contact Group, bringing together representatives of the ECB and the main players in the euro area money market, which has been very important for us when trying to understand the market structures, developments and functioning. The same can also be said about the corresponding Contact Group that we have on the foreign exchange side.
It is clear that we at the ECB have to adjust to the constantly evolving environment. In this respect, the accession of new central banks to the Eurosystem in the future will be a big challenge too. It will not only require a reassessment of the ECB's decision-making process, but also a reassessment of our monetary policy implementation process.