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European Monetary Policy

European Monetary Policy. Ankur Shah, Vice-President Christine Lee, Vice-President Emmanuel Durand, Associate Ling Chen, Associate Vallabh Muralikrishnan, Intern. Eurozone Countries.

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European Monetary Policy

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  1. European Monetary Policy • Ankur Shah, Vice-President • Christine Lee, Vice-President • Emmanuel Durand, Associate • Ling Chen, Associate • Vallabh Muralikrishnan, Intern

  2. Eurozone Countries • Adopted initially in 1999 by 11 countries, the Euro is now the official currency for 16 countries (in bold on the picture). • Slovakia was the last country to join the Eurozone in 01/2009. • Estonia is expected to be the next country to gain approval in 2010 for accession in 2011. • Several conditions apply to join the Eurozone: -excess inflation lower than 1.5% over the 3 lowest inflation member states -government deficit <3% -gross government debt over GDP <60% -having joined the exchange-rate mechanism for 2 consecutive years and not having devalued the currency during that period -excess nominal LT interest rate lower than 2 % over the 3 lowest inflation member states

  3. Setting the monetary policy • The ECB’s Governing Council is the decision-maker for the monetary policy. It meets twice a month: • At its first meeting, the Governing Council assesses the economic situation and the stance of the monetary policy. The decisions about the key interest rates are also taken during that meeting. • At its second meeting, the Governing Council focuses mainly on issues related to other tasks and responsibilities of the ECB. The Executive Board, which is the structure on the top of the Governing Council, is responsible for the implementation of the monetary policy defined by the Governing Council. • The representation of the Eurozone countries within the Governing Council ensures collaboration: • Each country is attributed one seat in the structure for the governor of the national central bank. • The heads of State of the Eurozone also appoint, by common accord, the 6 members of the Executive Board. Since 2003, the President of the ECB is Jean-Claude Trichet. The independence of the Governing Council is guaranteed through minimum duration mandates for the national bank governors and non-renewable mandate of 8 years for the Executive Board.

  4. The European Central Bank vs. The Federal Reserve • The European Central Bank’s tasks include: • The definition and implementation of monetary policy for the euro area • The primary objective of the ECB’s monetary policy is to maintain price stability • The conduct of foreign exchange operations • Foreign exchange operations include foreign exchange interventions and operations such as the sale of foreign currency interest income and so-called commercial transactions • The holding and management of the official foreign reserves of the euro area countries (portfolio management) • Ensure that ECB has sufficient liquidity to conduct its foreign exchange operations involving non-EU currencies • Use portfolio to provide ECB with income to help to cover its operating expenses and function as reserve (capital) to cover possible losses • The promotion of the smooth operation of payment systems

  5. The European Central Bank vs. The Federal Reserve • The Federal Reserve’s duties fall into four general areas: • Conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates • Supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers • Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets • Providing financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation’s payments system

  6. Trends in Real GDP Growth and Inflation in the Euro Area • The European Central Bank has historically done a great job fighting inflation in the Euro Area and kept consumer prices from growing only between 2-4 % • Between mid-2007 and 2009 the Euro area suffered a sharp fall in GDP due to the global financial crisis. Real GDP growth fell from 4% per annum to -4% per annum ( an unprecedented drop of 10%) • This fall in output was quickly followed by deflation as consumer prices fell by 4% between 2008 and 2009 • Due to the fiscal and monetary stimuli enacted by authorities, read GDP growth is projected to be an anemic 0-1% in 2010 but consumer prices are projected to increase at a slightly faster rate

  7. ECB Monetary Policy and the Taylor Rule • Recent Monetary Policy • Interest rates on the main financing operations, marginal lending facility, and the deposit facility have remained unchanged at 1.00%, 1.75% and 0.25% respectively since May 2009 • Taylor Rule and the ECB • Studies have found the ECB does not follow the linear Taylor rule, but is more forward-looking in expecting inflation and output growth • The ECB, unlike the US Federal Reserve, sets inflation and output growth target rates, which might be why they fared better in the financial crisis • Looking at contemporaneous Taylor rules, the ECB is accommodating changes in inflation and hence follows a destabilizing policy because their current rate is below their stated target rate

  8. ECB Monetary Policy and the Taylor Rule The European Central Bank closely watches inflation, with a target inflation rate of 2%. It is currently at .9% • If the ECB were following the Taylor Rule, with a1=a2=0.5, the rate would be 0.65% • If a1=0.75 and a2=0.25, then the repo rate would be 0.33%

  9. Short-Term Interest Rate Comparison: US and Eurozone • Both US and EZ short term rates exhibit moderate growth over the coming 9 months • While US rates grow less rapidly, there is also more debate over the projected evolution, indicating higher perceived riskiness

  10. Analyzing differences between the FRB and ECB • The Federal Reserve, as opposed to the ECB, has no explicit policy of inflation targeting • Historically inflation targeting has been met in the US with dissension and vocal opposition • Ben Bernanke, prior to joining the Fed, was a tenured professor at Princeton University, where he wrote papers advocating the use of explicitly stated inflation targets • However, after the then widely-acclaimed stable economic reign of Alan Greenspan, critics believed that such policy would lead to increased market volatility • The difference in objectives – the ECB primary focus on price stability, and the FRB broader economic focus – largely explains why the ECB will be more aggressive with short term rates • ECB is focused on taming inflation, which accounts for their higher short term rates • The Fed is also focused on unemployment and economic growth, and as a result has lower short term interest rates than the ECB • The recent crisis has more severely affected both the US banking industry and housing market over the Eurozone’s, which would also account for a need for lower interest rates in the US than the Eurozone

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