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The task of the European Central Bank The European Central Bank, the current embodiment of the EMS is an entirely independent institution with almost complete control over European Economic Policy (I. E. the Euro) and member states ability to jeopardize this is hindered by the stability pact which limits each member states ability to run a budget deficit. The European Central Bank could in fact be obliged to impose an excessively tight monetary policy and to raise interest rates in response to financial market skepticism as to the objective of price stability arising as the result of policies pursued by certain countries. The bank, very simply, would have complete control and the power to wield its authority, as it saw fit, with little consideration for the individual nations. Early efforts involved the Snake, the Snake In The Tunnel and the Exchange Rate Mechanism (which eventually had 15 % wide fluctuation bands).
The Maastricht Treaty of 1991 obliged all countries intending to enter into a single currency to meet convergence criteria. However, by 1998 the criteria (which related to inflation rates, interest rates, budget deficits, national debt and exchange rates) were being fudged and were being interpreted to suit particular circumstances of individual member states, John Mills goes as far as to indicate that some European economists believed that entry into the single currency was built on a foundation of false statistics and unsustainable trends. Furthermore, it must be noted that the criteria were solely related to financial variables and none of them to economic policies such as growth, full employment, and inflation at an acceptable (as opposed to the lowest possible) level. This danger had been pointed out by Keynesian economists in the early 1970 s. Possibly only Luxembourg truthfully matched the Maastricht criteria at the entry date of January 1 st 1999. It is this that was in part the cause of the difficulties in which the single currency has found itself.
The entry was greeted by celebration, self-congratulation and talk of a new era for economic and social advancement. But almost immediately problems arose. The euros value plummeted week by week. At the end of the first hundred days the euro had lost 10 % of its value against the dollar. Julian Coman at this time quoted a European Commission official as saying, we are not all converts. Frankly, one looks at the British economy, which is in the best state anyone can remember and has just worked out its own arrangements with its own independent central bank, and one wonders whether they are better off to stay out.
How effective the European Central Bank is in long run acceptability and credibility of the euro? I would like to compare ECB to FOMC to define the effectiveness of ECB first. ECB watchers have had a much less successful record at forecasting the immediate outcome of ECB meetings than "Fed watchers" do on the FOMC. Using data from regular Bloomberg surveys of analysts, taken just a few days in advance of policy meetings, we found that ECB watchers correctly forecast ECB rate changes just 36 percent of the time, compared with an accuracy rate of 86 percent for "Fed-watchers" and 64 percent for UK-based "MPC-watchers. " Undoubtedly, part of this poor performance by "ECB watchers" has resulted from the much higher frequency of ECB policy meetings, which during most of its first three years were running at a rate of twenty-four or twenty-five a year, compared with twelve for the Bank of England's MPC and just eight for the Fed's FOMC. In this sense, the ECB's decision last November to consider monetary policy actions at only its first meeting of the month is very welcome and should make future policy actions considerably more predictable. Meanwhile, here are ten "rules of thumb" to help investors better understand the ECB.
Much of the explanation for the ECB's different behavior to that of the Fed appears to result from a different mandate. The ECB's primary objective is "to maintain price stability"; only without prejudice to this may it then contemplate its secondary objective, "to support the general economic policies of the Community. " In contrast, the Fed's objective is "to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates. " The ECB's interprets price stability as harmonized CPI inflation over the medium term of "below 2 percent"; more recently officials have begun to imply that this represents a 1 - 2 percent range. Recall also that the ECB is a new institution, responsible for an economic region larger by population and geography, with a more inflation-prone history than the US, as well as being more diverse economically, politically, and culturally, than is the Fed. As such the ECB is still highly preoccupied with reputation building -- in particular, to emphasize to economic agents in the euro area that it will not tolerate inflation above 2 percent in the medium term. Another difference with the Fed is that the ECB's economics and research directorate works in principle for the GC as a whole, but its research tends to be aggregated by Chief Economist Issuing, who is said to open the meeting with an economic exposition that concludes with a recommendation on interest rates. In contrast, Fed Chairman Greenspan has de facto become the Fed's "Chief Economist" and therefore has exerted a degree of influence over the research conducted by the Fed's staff and its presentation to the FOMC.
That said, the ECB President does usually represent the ECB before the European Parliament and takes responsibility for monetary policy at the ECB press conferences, and therefore can still exert a high degree of suasion over the committee. The ECB's perception of the effectiveness of monetary policy appears to differ from that of the Fed. It would argue that above all monetary policy should be "stability-oriented" -- a legacy of Bundesbank thinking. It regards Europe's growth prospects as best achieved through achieving a high rate of investment, which in turn requires low and stable long-term rates. It sees these as particularly important for Europe, given a higher dependency of corporate and household financing using long-term rates. The ECB focuses less than the Fed on stock market movements, partly because it does not believe that equities play much role in affecting the euro area economy.
It does, however, pay close attention to (and takes considerable pride in) inflation expectations derived from index-linked bonds. As well, the volatility of the euro and its potential impact on the formation of inflation has meant that the currency's external value has assumed proportionately more importance in ECB considerations and actions than it has for the Fed (which has traditionally paid scant attention to the dollar's value). The ECB appears to have a stronger preference than the Fed to minimize volatility in its official policy rate (the "repo rate"). It therefore has a very "gradualist" approach that, it believes, helps to foster lower long-term rates (by lowering the risk premium). In general, it would prefer not to reverse interest rate decisions within a considerable time-span -- indeed, some officials would doubtless have preferred, with the benefit of hindsight, not to have lowered rates 50 bp in December 2002 only to reverse this decision seven months later. Overall, the ECB eschews "fine tuning" -- it does not believe that it has sufficient historical and forward-looking information about the business cycle to be able to deliver a counter-cyclical policy, especially given its belief that there are considerable lags in the interest rate transmission process -- of "a number of quarters or even years. " That said, it is not unresponsive to the economic cycle -- for example, it lowered interest rates 150 bp last year, 100 bp of which came in two 50 bp installments, on September 17 and November 8.
On account of its collegiate nature, the Governing Council therefore seeks a high level of consensus prior to changing policy. In an interview President Duisenberg reportedly commented last year that he would rather that the ECB deferred a contentious decision to change interest rates to such a time when the decision commanded more widespread support on the GC. This is not to say that all ECB decisions are unanimous -- although the ECB's minutes are not published, there is evidence to suggest that it will take decisions even if agreement is not reached with all eighteen GC members. But there has undeniably been a tendency for the ECB to lag, rather than lead, money market expectations, both on the upside and downside.
This arises partly from the collegiate nature of decision taking and partly from the ECB's self evidently gradualist approach. During the first year of the euro (1999) the ECB altered interest rates just twice -- it lowered rates 50 bp to 2. 5 percent in April and raised them back to 3 percent in November. This led to the view at the time that the ECB would prefer to change rates infrequently, entailing perhaps some inclination for 50 bp rather than 25 bp. Since the start of 2000, however, there have been only three rate changes of 50 bp -- in June 2000 and in September and November 2001. The remaining seven rate changes were of 25 bp only. It would appear that the magnitude of rate changes does depend on what particular circumstances, and interpretation thereof, were behind the action.
For example, the June 15, 2000 rate increase of 50 bp was justified at the time as resulting from the need to signal a clear horizon since it coincided with a major change to the procedure in the ECB's money market operations. The implication then was that were the ECB not to have switched to a variable rate repo, it would have perhaps been more inclined to move by 25 bp. The ECB jealously protects its high level of independence, and a consequence of this is that the more vocal the pressure from politicians on the ECB to act, the less likely the ECB is to do so. Perhaps the best example of this was in March 2002, when German Finance Minister Lafontaine publicly urged the ECB to cut rates, and attended its early March meeting as chairman of the euro group of finance ministers. The ECB desisted, but lowered rates 50 bp at their March 8 meeting, which was shortly after his resignation. This was a crucial defining period whereby the ECB demonstrated that it was in charge of monetary policy.
The ECB takes comfort from independent assessments suggesting that, on the whole, it has conducted monetary policy in an appropriate way, but has acknowledged that it has not always well communicated its process. In particular, it appears in retrospect to acknowledge that its 25 bp rate cut on May 10, 2001 surprised the markets. Shortly after...
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Research essay sample on European Central Bank Interest Rates
