Monetary policy in the EU is overseen by the European Central Bank (ECB). It is up to the ECB to ensure that prices in the EU are stable, which means close to - but under - 2%. This range is designed to decrease the risk of deflation. The ECB also manages interest rates and money supply for the whole EU, and injects liquidity into the system as necessary. All EU member states, upon joining the EU, must give up much of their central bank’s power to the management of the ECB.
The ECB is primarily concerned with the real economy, or the levels of real income and employment. The ECB believes that the real economy is not determined by the money supply, and this belief informs much of its economic philosophy. Thus, the ECB works to achieve short term price stability as a means to long term neutrality of money, by apply short term interest rates.
The ECB meets twice each month to set interest rates across the EU and determine the quantity of money in circulation. These policy tools allow the ECB to control inflation in the euro area and inject liquidity when necessary.
Generally speaking, the ECB:
As regards the borrowing rates of the various member states or so called sovereign bonds (OAT in France, Bund in Germany, etc.) they were pretty close to each other until the financial crisis. But then, increasing differences in growth rates, fiscal deficits, trade balances, and housing prices in the various euro area countries were causing problems in some countries.
Since then, the borrowing cost of some countries went up, while the ECB kept on decreasing the main rate until negative territories. Thus, the financial crisis triggered significant differences between member states and the recent shift in European monetary policy.
Recently, EU growth rates have fallen behind USA and UK growth rates. Some attribute this poor growth record to the inflexible economies of the EU member states, and believe that Europe’s underlying economic problems are a result of bad supply-side performance rather than ineffective demand-side monetary policy.
The ECB concurs with this view, and recognizes that national governments and their failure to keep up with globalization are more responsible for the recent growth problems than ineffective monetary policy. Additionally, the ECB has hesitated to lower interest rates historically because of a fear of raising inflationary expectations. However, since the recent financial crisis, the ECB has been forced to reduce interest rates to a record low of 1.5%, and they continue to be lowered as the economic downturn worsens.
Those who argue with the ECB’s policies contest that any kind of monetary or fiscal stimulus policy is worthless unless the economy is flexible, and that the ECB’s interest rate reductions may simply contribute to higher prices. Critics also argue that fiscal stimulus policies could cause balance of payments problems and crowd-out the private sector economy.
The EU recently established the Stability Pact, which constrains the fiscal stimulus that the ECB is able to provide. That being the said, the financial crisis has led to unprecedented levels of debt that the Pact failed to predict or account for. The EU is working towards a system that will allow it to control national budgets during the ongoing sovereign debt crisis.
The aim of the QE is to ease monetary and financial conditions to the point where both households and firms are able to borrow, spend, or invest money.
Since the debt crisis, deflation is now a serious concern in the EU. As part of the QE program, the ECB plans to inject 1.1 trillion euros to economies of EU member states via the purchase of corporate and government bonds. The QE program now consists of making 80 billion euros worth of asset purchases each month (it was 50 until Dec.-16).
The purchase plan includes sovereign bonds in addition to the existing private sector asset purchase program, which the ECB hopes will prevent too long a period of lowered inflation and avoid deflation in the euro zone and, ultimately, build up aggregate demand in the EU economy.
By Spring of 2016, unease about the negative interest rates was growing amongst top central bankers. Mario Draghi, president of the ECB, responded to this concern about the status of the ECB’s QE program. Mr. Draghi announced that interest rates would remain at their current low for “an extended period.” However, he said that he did not anticipate lowering the negative rates even further out of concern for the banks: “Does it mean we can go as low as we want without having any consequences on the banking system? The answer is no.”
Experts are analyzing these statements as a sign that the ECB is recalibrating its arsenal of monetary policy tools and refocusing its efforts on strengthening the EU economy rather than weakening its currency.
The ECB also broaded the range of bonds and assets that it will purchase each month to include high-quality corporate bonds. It also cut the main refinancing rate by 5 basis points, to 0 percent.
Finally, the ECB decided not to aid banks by offering a tiered rate scheme, as has been implemented in Japan. Mr. Draghi announced that the ECB did this partly out of a “desire not to signal we can go as low as we want,” but also because the EU banking system is complex and diverse compared to that of Japan.
Earlier this year, Mr. Draghi announced that economic growth was “weaker than expected,” burdened by economic problems in emerging markets, financial volatility, and slow economic reform in the EU.