What is monetary policy and how it affects your income?
If one compared the euro area economy with the human body, money circulating in it would serve as blood, and the European Central Bank (ECB), which influences the price of money – interest rate, would constitute its heart. Just as the heart affects the functioning of the whole body, actions of the ECB strongly impact euro area economic developments, household and business borrowing conditions and the general price level. Decisions on the future stance of euro area monetary policy will be taken this June in Vilnius.
Mindaugas Liutvinskas, Head of the Economic Policy Analysis Division of the Bank of Lithuania.
Key aspects of monetary policy
The Eurosystem – the ECB, together with the national central banks of the euro area member states – shapes and conducts the single monetary policy. In other words, it steers interest rates in euro by using a range of monetary policy instruments. Lower interest rates stimulate business and household borrowing, thus increasing the supply of money in the economy. This, in turn, creates conditions for stronger economic growth and, in the longer term, influences the price level. Higher interest rates tend to curb possibilities for borrowing and, as a result, money supply decreases, the economy shifts into a lower gear and finally price growth weakens.
However, in the period since the global financial crisis, the world’s main central banks have started taking additional measures, such as quantitative easing, as well. Such non-standard monetary policy measures are primarily intended for attaining monetary policy objectives when interest rates are close to zero or even turn negative, yet inflation growth still trails behind.
Monetary policy developments affect everyone
The primary objective of the ECB’s monetary policy is to maintain price stability. This objective is important to everyone as it supports household purchasing power, ensuring that it would not be dragged down by excessively rising prices.
The ECB aims at keeping inflation rates below, but close to, 2% over the medium term. Such inflation target is rather low, but it helps to avoid a deflationary spiral that, as a result of declining prices, could hinder economic growth in the long run. Notably, the price growth rate is calculated at the euro area level, therefore, in individual countries in certain periods this rate can be lower or higher, depending on country-specific circumstances. Currently, in the euro area, the rate accounts for 1.4% and in Lithuania – 2.4%.
Monetary policy has a significant effect on crediting conditions for both businesses and households. Commercial banks borrow from central banks or hold deposits with them, therefore, the price they pay for these facilities affects the final client. For example, the ECB interest rates influence commercial bank conditions applied to Lithuanian residents taking housing loans or companies borrowing funds for business expansion.
Accommodative monetary policy, which is currently being implemented in the euro area, ensures favourable financing conditions, and, in turn, provides an additional boost to economic growth. How long the current lending conditions will last depends on monetary policy decisions taken at the ECB Governing Council meetings. The next such meeting will be held in the beginning of June, in Lithuania.
Key monetary policy decisions will be taken in Vilnius
The ECB’s Governing Council is the main euro area monetary policy decision-making body. At this time, it consists of 25 members: the governors of the national central banks of the 19 euro area countries and the Executive Board (the President and Vice-President of the ECB and 4 other members).
The Governing Council usually meets twice a month at the ECB’s premises in Frankfurt am Main, Germany. However, once a year it holds an external meeting in one of the euro area countries. This year, the external meeting will be hosted by Lietuvos bankas and will take place in Vilnius on 5-6 June.
The Governing Council regularly assesses euro area economic situation and monetary policy developments, sets key interest rates and takes decisions concerning other monetary policy measures, while the key decisions are usually taken unanimously. At the upcoming meeting, the latest data on the euro area economic situation and revised macroeconomic forecasts will be analysed. After the meeting, a press conference will be held, typically attracting worldwide media attention. During the conference Mario Draghi, President of the ECB, together with the Chairman of the Board of the Bank of Lithuania, will explain the monetary policy decisions taken, which are usually closely followed by the international financial markets.
After joining the euro area – more monetary policy levers
The Governing Council meeting in Vilnius can be viewed as a symbolic gesture, cementing Lithuania’s place in the euro area. The fact that key monetary policy decisions will be taken in Vilnius shows that our country is a fully-fledged member of the common currency area.
Participation in the formation of single monetary policy also allows denying the incorrect, yet often heard, assertions that supposedly Lithuania “lost its monetary autonomy when it joined the euro area”. However, it is worth remembering that prior to the adoption of the euro, Lithuania did not conduct monetary policy independently. Since 1994, Lithuania had maintained the currency board regime, according to which litas was pegged to a stable foreign currency at a fixed rate: initially to the US dollar, and since 2002 – to the euro. This fixed exchange rate model was best suited to the interests of Lithuania as a small and open economy.
In 2002, Lithuania became an “importer” of the euro area monetary policy: it was directly influenced by the policy but could not participate in its adoption. The situation changed when the euro was adopted on 1 January 2015 – Lithuania became a member of the euro area, and the Bank of Lithuania joined the Eurosystem.
The Governing Council, where Lithuania is represented by the Chairman of the Board of the Bank of Lithuania, applies the “one country, one vote” principle, meaning that, in practice, Lithuania’s vote carries the same weight in the decision-making process as those of the large euro area countries. In other words, having become a fully-fledged euro area member, Lithuania not only did not lose monetary autonomy but joined the “highest league” and gained genuine levers to contribute in shaping the single monetary policy of the 19 euro area countries.