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Monetary policy

The primary objective of the Eurosystem is to maintain price stability and, thus, the purchasing power of the euro. In order to achieve this objective, the Governing Council has adopted a monetary policy strategy that includes a quantitative definition of price stability. The reference indicator is the Harmonised Index of Consumer Prices (HICP). Price stability is defined by the Governing Council as a year-on-year increase of the HICP of below, but close to 2% over the medium term. As price stability is defined with respect to the euro area as a whole and not to the inflation rates of individual countries, the Governing Council works in the common interest of the euro area.

In order to take decisions based on comprehensive information, the Governing Council conducts a double analysis. First, it examines a broad range of economic and financial indicators which are likely to give indications on the future evolution of prices. This assessment is then cross-checked through a monetary analysis, which assesses credit and liquidity developments.

The transmission mechanism of monetary policy

In order to reach its objective, the central bank does not exert a direct influence on prices, but rather on interest rates. Hence, the single monetary policy sets the level of interest rates at which the Eurosystem lends to commercial banks in the short term, which has an indirect impact on the interest rate proposed by the commercial banks to their customers (individuals and businesses).

The setting of the level of interest rates has an important impact on the quantity of money in circulation and consequently, on inflation. Indeed, if the interest rates rise, credit becomes more expensive and therefore scarcer – while at the same time, saving becomes more profitable. This allows reducing inflationary pressures via the lowering of global demand.

Monetary policy operations

The central banks of the Eurosystem have a set of monetary policy instruments at their disposal: open market operations, standing facilities and reserve requirements.

Open market operations consist of :

  • Main refinancing operations, which aim to provide liquidity on a regular basis and which take place once a week and have a maturity of one week. They normally serve to signal the stance of monetary policy in the euro area;
  • Longer term refinancing operations, with a monthly frequency and a three-month maturity;
  • Fine-tuning operations can be executed on an ad hoc basis to manage the liquidity situation in the market and to steer interest rates. Their aim is to mitigate the effects on interest rates caused by unexpected liquidity fluctuations;
  • Structural operations can be carried out by the Eurosystem through reverse transactions, outright transactions and issuance of debt certificates.

Furthermore, the Eurosystem offers standing facilities which aim to provide and absorb overnight liquidity, as well as to signal the general monetary policy stance and set upper and lower limits to overnight market interest rates.

Two standing facilities are available to eligible counterparties at their own initiative:

  • The marginal lending facility, which counterparties can use to obtain overnight liquidity from the NCBs against eligible assets. The interest rate on the marginal lending facility normally provides a ceiling for the overnight market interest rate;
  • The deposit facility, which counterparties can use to make overnight deposits with the NCBs. The interest rate on the deposit facility normally provides a floor for the overnight market interest rate.

Finally, credit institutions in the Eurosystem are required to hold minimum reserves with central banks. The objective of the minimum reserve system is to pursue the aims of stabilising money market interest rates, creating (or enlarging) a structural liquidity shortage.

 

 

For more information, see: Monetary policy