The European Central Bank’s (ECB) ongoing monetary policy involves interest rates and asset purchases. It affects bond yields, exchange rates, and equities, shaping market sentiment and investment decisions. Staying updated enables traders to make informed choices, manage risks, and seize trading opportunities.
Let us dive deeper into learning about ECB’s current monetary policy.
What is the ECB?
The ECB is the central bank for the Eurozone, founded in 1998. Based in Frankfurt, Germany, its main goal is to ensure price stability by controlling inflation through actions like setting interest rates and regulating the money supply. It influences the euro currency, economic conditions, and financial markets both positively and negatively.
Elements of the current monetary policy
Amidst declining inflation but rising concerns about its persistence, the ECB’s Governing Council has decided to restore inflation to its 2% target as of July 27, 2023. Thus, a 25 basis points increase in the three key ECB interest rates has been approved. Future decisions will maintain these rates at suitably restrictive levels until the target is met, guided by data-driven analysis of economic and financial indicators, underlying inflation dynamics, and monetary policy transmission strength.
The main refinancing operations of the ECB include routine reverse transactions designed to infuse liquidity, typically spanning a week. National central banks undertake these decentralized actions through standard tenders, following a schedule available on the ECB’s website. As of July 27, 2023, The refinancing operations, marginal lending, and deposit facility rates will rise to 4.25%, 4.50%, and 3.75%, respectively, starting from August 2, 2023.
Concurrently, the Governing Council will consistently evaluate the impact of targeted lending operations and their gradual repayment on the overall monetary policy approach, especially as banks repay funds obtained through targeted longer-term refinancing operations. The current ECB Main Refinancing Operations Interest Rate of 4.25% on July 27, 2023, was higher than 4.00% on its previous day and witnessed a much notable increase from 0.50% last year (2022). The current rate has also surpassed the long-term average of 2.00%.
Asset purchase programs
The ECB employs the asset purchase program to enhance the transmission of monetary policy and facilitate favorable financing conditions. This initiative involves acquiring government bonds, national and European institution bonds, corporate bonds, and covered bonds from banks.
As of a December 2022 decision, the ECB has outlined methods to gradually reduce the Eurosystem’s securities holdings within the program beginning March 2023, initially decreasing the portfolio by an average of €15 billion monthly until June 2023. This is because the Eurosystem is not going to invest all its principal payments receivable from maturing securities. The Governing Council will consistently review the reduction pace to align with monetary policy goals, market functionality, and money market control.
Building upon the decision made in December, the Governing Council has now established specific procedures for decreasing the Eurosystem’s securities holdings within the asset purchase program (APP). This reduction will occur through the partial reinvestment of principal payments from maturing securities.
During this phase of partial reinvestment, the Eurosystem will adhere to its current reinvestment approach. Notably, the monthly redemptions between March and June 2023 within the APP will surpass the predefined average runoff rate of €15 billion per month. These increased partial reinvestments, exceeding €15 billion monthly, will ensure a consistent market presence for the Eurosystem throughout this period of the APP.
Pandemic emergency purchase programs
The ECB introduced the pandemic emergency purchase program (PEPP) in March 2020 as a measure to address the significant threats due to the COVID-19 outbreak to the monetary policy transmission and the euro area’s outlook. To enhance its impact, the Governing Council increased the initial €750 billion investment by €600 billion on June 4, 2020, and by €500 billion on December 10, resulting in a new total of €1,850 billion.
Starting December 16, 2021, net asset purchases under the PEPP were discontinued as decided by the Governing Council as of the end of March 2022. However, the maturing principal payments from securities obtained through the PEPP will continue to be reinvested until at least the end of 2024. The future reduction of the PEPP portfolio will be managed to avoid impacting the suitable monetary stance. Furthermore, to counter risks linked to the pandemic’s effects on the monetary policy transmission mechanism, the Governing Council will maintain flexibility in reinvesting redemptions from the PEPP portfolio.
Symmetric inflation target
In December 2022, ECB staff projections saw a significant upward revision in the medium-term inflation outlook. Projections indicated headline inflation reaching 3.4% by 2024 before easing to 2% in Q3 2025, while core inflation was expected to remain above target and average 2.4% by 2025. Recently, the ECB has adjusted its inflation target to 2% as part of a revised strategy called the symmetric inflation target strategy.
This move was prompted by the need to adapt to structural economic changes over the last few decades. The term symmetric signifies the equal undesirability of inflation surpassing or falling below the target. The strategy also recognizes that when the economy operates near the lower limit of nominal interest rates, substantial and persistent monetary policy actions become necessary. This could entail a temporary phase in which inflation moderately exceeds the target.
One key change was the decline in the equilibrium real interest rate, dropping from around 3% at the monetary union’s inception to near or below zero pre-pandemic. This shift limited conventional interest rate policy’s effectiveness, leading to the new strategy with a symmetric 2% inflation target over the medium term, acknowledging the need for forceful monetary policy action near the lower bound on nominal interest rates, even if it entails temporary above-target inflation.
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ECB’s monetary strategy for inflation and economic challenges
The ECB’s prevailing monetary policy aims to restore inflation to its 2% target. Employing interest rate adjustments, asset purchases, and a new symmetric approach, the strategy addresses the challenges of low rates and acknowledges the need for assertive measures when near nominal interest rate limits.
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