The First 5 Years of Monetary Policy of the Ecb

The first 5 years of monetary policy of the ECB

1. Introduction

Since 1 January 2001 the euro is the currency of 12 European countries. Only three of the European Union (EU) Member States, Denmark, Sweden and the United Kingdom have refused to introduce the euro. Four years earlier, on 1 June 1998, the European Central Bank (ECB) was established to be in charge of

monetary policy for the Euro area. The introduction of the euro and the establishment of the ECB were both realizations of the European Monetary Union. Three individual stages should lead to this European Monetary Union.

1. (1990) Restrictions on the movement of capital between Member States were abolished.

2. (1994) Strengthen central bank cooperation and monetary policy coordination and preparations required for the establishment of the European System of Central Banks (ESCB), consisting the ECB and the local national central banks of all EU Member States.

3. (1999) fixing of the exchange rates of the currencies of the Member States participating in Monetary Union.

The ECB was now legally responsible for the conduct of the single monetary policy in the Euro area. To sum these stages up, the ECB is the central bank for Europe's single currency, the euro. The ECB's task is to maintain the euros purchasing power, thus obtain price stability. This paper will describe the ECB's monetary policy strategy and its individual monetary policy instruments. Finally the paper will describe the direction and actions of the monetary policy in the Euro area of the first five years (1999-2003).

2. Objective of the monetary policy

The primary objective of the ECB is price stability. However, the Maastricht Treaty does not precisely specify a definition of price stability or a time frame in which this objective should be achieved. Summarized, the way of achieving this goal is called the monetary policy strategy. The ECB has to influence the level of short-term interest rates, to make sure that price stability is maintained over the medium term. Since there is a time lag how the price level changes after a change in monetary policy, the ECB must be forward looking. This time lag in implementing monetary policy usually starts to affect the price level after a number of quarters or even years.

3. Monetary Policy between 1999 and 2003

This chapter will analyze the first five year since the ECB is responsible for monetary policy in the Euro area. This environment was mainly dominated by price shock to the market, as described below. There can be three stages distinguished as regards the direction of monetary policy in the Euro area between 1999 and 2003: the first stage represented by the period between the launch of the ECB until the summer of 1999, the period between the summer 1999 to late 2000 and finally the period which started in spring 2001. In 1999, the ECB was established and became responsible for monetary policy. The Governing Council started its operations at a time when interest rates were at a very low level. The first interest rate on the main refinancing operations was set at 3%, the marginal lending facilities at 4.5% and the deposit facilities at 2%.

In early 1999 a combination of factors increased downward risks to price stability lowering the HICP inflation below 1% (see Figure 2).

Downside risks to economic growth as a consequence of weaker external demand coming from the Asian crisis of 1997 and the drop in confidence that followed the financial market decrease after the Russian crisis of 1998.

Thus, on 8 April 1999 the Governing Council decided to reduce the main refinancing rate to 2.5%, the marginal lending facilities to 3.5% and the deposit facilities to 1.5%. The economic environment improved steadily associated with an increasing growth in real GDP from summer 1999 into 2002 in the Euro area (see Figure 3).

Simultaneously import prices increased and the exchange rate of the euro depreciated during that period, consequently HICP inflation increased above 2%, the ECB's quantitative definition of price stability. These events forced the Governing Council to increase the key ECB interest rates in a series of steps between November 1999 and October 2000. The main refinancing rate was increased up to 4.75%, the marginal lending facilities to 5.75% and the deposit facilities to 3.75% (see Figure 4). HICP inflation increased in early 2001, peaking at 3.4% in May. Already by late 2000 the global economy was showing indications of a slowdown in economic growth and thus in real GDP growth. Besides the increasing inflation rate, the annual monetary growth M3 declined in early 2001 and stayed below the reference value set by the ECB. The weakening of the economic growth signalled lower inflationary pressures and therefore the Governing Council lowered the key ECB interest rates by 0.25% on 10 May and again on 30 August 2001 The terrorist attacks on 11 September 2001 and the Wars in Afghanistan and Iraq increased the degree of economic uncertainty in 2001 and therefore had the potential to intensify the downward trend in economic activity and inflation pressure was expected to decline. Following an extraordinary teleconference on 17 September 2001, the Governing Council reduced the key interest rates by 0.5%. After the terrorist attacks the inflation pressure continued to decline in the second half of 2001 and in early 2002. The Governing Council again reduced its key interest rates in November 2001. It decided to reduce the main refinancing rate to 3.25%, the marginal lending facilities to 4.25% and the deposit facilities to 2.25%. Nevertheless, HICP inflation remained above 2% in 2002. In addition, the annual monetary growth M3 increased