European monetary policy: key pillars and mechanisms

The workings of European monetary policy are sometimes obscure to the uninitiated. Yet this mechanism influences our economies on a daily basis. This article deciphers the objectives and instruments that define this major Community policy.

1. Main objectives of the ESCB

Price stability as an absolute priority

The primary mission of the European System of Central Banks (ESCB) is clear: to maintain price stability. This mandate, enshrined in Article 105 of the Treaty on the Functioning of the European Union (TFEU), is the compass that guides all European monetary actions.

The European Central Bank (ECB) has clarified this concept. It defines it as "an increase in the Harmonised Index of Consumer Prices of less than 2% per annum for the euro area over the medium term". This definition avoids two major pitfalls: galloping inflation and deflation. It strikes a delicate balance.

Support for economic policies

The same Article 105 of the TFEU states: ". without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community" . This hierarchy is crucial. The ECB can support other objectives such as growth or employment, but only if price stability is not threatened.

However, there is a strict limit: the ECB is formally prohibited from directly financing public deficits (Article 101 TFEU). This provision was at the heart of many debates during the sovereign debt crises.

Constantly monitored indicators

To steer its policy, the ECB follows two "pillars" of analysis:

1. The M3 monetary aggregate (cash + sight deposits + short-term deposits), with a target growth rate of 4.5%.
2. A set of leading economic indicators: wage trends, inventories, exchange rates and industrial prices.

These data form a dashboard which guides the decisions of the ECB Governing Council.

2. Monetary policy instruments

Open market operations: the main lever for action

The ECB mainly acts on the liquidity of the banking system through its open market operations. There are four types of intervention:

• Main refinancing operations (MROs): These weekly operations provide 75% of the Eurosystem's refinancing. The rate of these operations (minimum bid rate) is the main monetary policy signal.
• Longer-term refinancing transactions: monthly with a maturity of three months.
• Fine-tuning operations: exceptional, they correct unforeseen liquidity imbalances.
• Structural transactions: these are very rare, but they bring lasting changes to the market's liquidity structure.

These interventions take the form of loans secured by securities ("reverse repos") or outright purchases/sales.

Standing facilities: a rate corridor

Unlike open market operations initiated by the ECB, standing facilities are used at the initiative of banks. They create a "corridor" that frames market rates:

• The marginal lending facility allows banks to obtain overnight liquidity (at 3% in 2003).
• The deposit facility enables them to invest their temporary surpluses (1% in 2003).

These rates form the upper and lower limits of the interbank rate.

The minimum reserve system: creating a structural requirement

Reserve requirements oblige banks to deposit with their National Central Bank (NCB) a percentage of certain items in their liabilities. This mechanism has two functions:

1. Create a structural need for refinancing, enabling the ECB to intervene effectively on the market.
2. Stabilise short-term interest rates by allowing banks to meet these obligations on average over one month.

The current reserve requirement is 2% for demand and short-term deposits and 0% for longer-term deposits.

3. Foreign exchange operations

A subtle division of powers

The Treaty establishes a division of responsibilities for exchange rate policy:

• The ECOFIN Council (finance ministers) has the power to take strategic decisions on exchange rate policy (article 111 TFEU).
• The ESCB, via the ECB, is responsible for "conducting foreign exchange operations" in accordance with these guidelines.

This architecture reflects a delicate political balance between national sovereignty and the autonomy of monetary policy.

Managing foreign exchange reserves

The ESCB's foreign exchange reserves break down as follows :

• The ECB, which holds around 50 billion euros in foreign currencies (mainly US dollars).
• The NCBs, which manage most of the reserves (around 300 billion dollars in 2002).

To prevent national transactions from influencing the euro exchange rate, transactions above a certain amount require prior authorisation from the ECB (article 31 of the ESCB Statute).

Intervention on the foreign exchange market

In practice, the Council's doctrine is that exchange rate guidelines should only be issued in exceptional cases, where there is a "clear misalignment" between the euro and other currencies.

Intervention can be carried out by the ECB directly or by the NCBs on instructions from Frankfurt. This operational flexibility allows interventions to be adapted to market conditions.

4. Payment systems

TARGET: the backbone of European payments

TARGET (Trans-European Automated Real-time Gross settlement Express Transfer) is the central infrastructure for euro settlements. It interconnects the 15 national real-time gross settlement systems.

In 2002, TARGET processed more than 250,000 transactions daily, worth more than 1,500 billion euros. This system is vital for :

• Execution of monetary policy.
• Reducing systemic risk.
• Cash management for large European companies.

An improved version (TARGET 2) is planned for 2006-2010, with greater adaptability to EU enlargement.

Promoting efficient payment systems

In addition to TARGET, the ESCB is helping to improve retail payments. The Single Euro Payments Area project aims to make cross-border transactions as simple and cost-effective as domestic payments.

The ECB also actively monitors existing payment systems, checking their compliance with international standards, in particular those established by the Bank for International Settlements (BIS).

Prudential supervision

The ESCB contributes to financial stability by participating, via opinions and consultations, in the prudential supervision of the financial sector. Ten of the twelve Eurosystem countries involve their NCBs directly in banking supervision.

Coordination work is carried out on an ongoing basis to prevent systemic risks, which are particularly important in an integrated financial market where the failure of a major player could trigger a domino effect.

Sources

• Articles 105, 101 and 111 of the Treaty on the Functioning of the European Union (TFEU).
• Protocol No. 3 on the Statute of the European System of Central Banks and of the European Central Bank, in particular Articles 14.3, 31 and 35.6.
• General ECB documentation on Eurosystem monetary policy instruments and procedures (2002).
• ECB Monthly Bulletin and Annual Reports.
• Document " European System of Central Banks and Banque de France" Gabriel Montagnier, Répertoire de droit commercial, February 2004.