How monetary policy works
The Eurosystem’s monetary policy strategy is based on the definition of price stability and the so-called two-pillar approach, i.e. the economic and the monetary analysis.
The first pillar – economic analysis – includes the analysis on how prices are affected by the overall state of domestic economy, the indicators of wages, tax dynamics and other economic developments.
The second pillar – monetary analysis – includes the analysis on how the changes in monetary aggregates affect inflation and economic growth.
The ECB implements monetary policy by setting short-term interest rates, thus influencing price stability and the pace of economic development in the euro area over the medium term.
Monetary policy affects economy through various channels and in different time horizons, whereas the size of its full impact depends on many variables. The process through which monetary policy decisions influence economy and, in particular, the price level is called monetary policy transmission.
Official interest rates: what are they and how do they work?
The setting of official interest rates is the main standard monetary policy instrument. The central bank uses these interest rates to provide funds to or borrow from the banking system. The change in official interest rates may affect:
- short-term money market interest rates and expectations;
- bond yields;
- bank borrowing and lending rates as well as credit and money supply;
- saving and investment decisions;
- asset prices and exchange rates;
- aggregate demand and prices.
How do monetary policy decisions affect economy and prices?
Changes in the ECB official interest rates affect short-term money-market interest rates directly, while lending and deposit rates, which are set by credit institutions, are affected indirectly. Monetary policy decisions influence market expectations about the levels of future official interest rates, thus affecting medium- and long-term interest rates.
Changes in interest rates determine loan demand by making credit for consumption and investment more or less attractive. Movements in asset prices also have an impact on consumption and investment decisions via effects on wealth and the value of collateral. For example, higher asset prices increase wealth, which may lead to higher consumption, and raise the value of collateral, which, in turn, may lead to higher demand for credit.
Transmission channels of monetary policy decisions
The traditional bank lending channel focuses on loans supplied. In addition to this channel, there is also a risk-taking channel, constituting banks’ incentive to bear risk related to the provision of loans (the incentive may change). This channel works in two ways. Since interest rates affect asset prices and the value of collateral, they may either encourage borrowers and banks to accept higher risks or deter them from doing so. Interest rates may also either encourage economic agents to search for higher yields and riskier assets or deter them from doing so.
Monetary policy decisions influence market expectations and financing conditions, and may trigger changes in asset prices and exchange rates. By altering import prices, changes in the exchange rates can affect inflation directly, but they may also work through other channels indirectly.
The changes in consumption and investment caused by monetary policy trigger changes in the demand of goods and services, thus accelerating or decelerating the rise in prices. In addition, changes in demand may impact conditions in the labour market, the market of intermediate goods and services as well as affect their prices.
The Eurosystem seeks to ensure that the inflation expectations of companies and other economic agents are in line with the definition of price stability. Accordingly, such expectations would also influence the price-setting behaviour of enterprises.
Since the intensification of tensions in financial markets in 2007 and the global financial crisis in 2008–2009, the Eurosystem, like other major global central banks, has started applying a number of non-standard monetary policy measures alongside the standard ones. First and foremost, they include large-scale lending for longer periods and purchasing of longer-term bonds. Soon, non-standard measures became key monetary policy instruments. Since March 2015, the Eurosystem’s main non-standard measure has been the expanded asset purchase programme, also referred to as quantitative easing. When implementing this programme, central banks within the Eurosystem purchase high volume of debt securities issued by the public and private sectors.
How does quantitative easing work?
The expanded asset purchase programme aims at bringing inflation rates back to the level provided in the definition of price stability, thus heading off deflation. By implementing this programme, economy is stimulated through the following main channels:
- the direct impact channel, by driving down the yields on bonds purchased under the programme;
- the credit channel, by easing corporate and household financing conditions;
- the investment portfolio rebalancing channel, which transmits the effects of the first two channels to other financial markets. The programme stimulates investors to change the composition of their investment portfolios by stepping up purchases of debt and equity securities and other financial assets not included in the scope of the programme;
- the signalling channel, by communicating the Eurosystem’s commitment to maintain a high degree of monetary accommodation for an extended period of time.