Monetary policy in the euro zone

1. Monetary policy in the euro zone Siddharth Choraria, Erik Dangremond, Amit Das, Kiley Dean Delgado, Cesar Herrera, Urvashi Kumar Chief Economists for Euro Zone Markets Deutsche Bank, London, UK

2. Introduction to the Euro Zone: Purpose, Operations, Member Countries The European Central Bank (ECB): How Does it Compare to the Federal Reserve Economic Conditions in the Euro Zone ECB: Monetary Policy Historical Evolution of Short-Term Interest Rates (ECB vs. Federal Reserve) Page 1 Page 2 Page 3 Pages 4-5 Page 6 Bonus Section: The Economic Crisis in Greece Page 7 Table of Contents

3. History • Collaboration • The European System of Central Banks (ESCB) consists of the National Central Banks (NCBs)of each member country and the European Central Bank (ECB). According to the EC Treaty and the Statute of the ESCB, both the ECB and the NCBs have complete independence. By this it means that each entity must act without influence from the governments of any member country. As such, it can focus on its primary mission of creating price stability. • By statute the ESCB is decentralized, so the ECB and NCBs jointly contribute to attaining the Euro system's common goals. The ECB is responsible for setting the monetary policies for the Euro. This is done through its Governing Body. NCBs are then responsible for executing these policies. However, it is the ECB’s responsibility to ensure that these policies are executed properly and consistently. To ensure collaboration, the Governing Council consists of the ECB Board as well as the governors of each of the 16 NCBs. • Member Country EU Succession Date GDP (2009) • The Euro Zone consists of all 16 EU member countries that use the Euro as their sole currency. This came to be in January 1999 , mainly as an extension of the European Union’s aim to create closer cooperation amongst member countries. According to the European Commission, the Euro is meant to produce the following benefits: • More choice and stable prices for consumers and citizens • Greater security and more opportunities for businesses and markets • Improved economic stability and growth • More integrated financial markets • A stronger presence for the EU in the global economy • A tangible sign of a European identity Introduction to the Euro Zone * All members of the European Union are required to convert to the Euro except for the United Kingdom and Denmark. Other EU countries yet to convert to the Euro are: Czech Republic, Hungary, Estonia, Latvia, Bulgaria, Lithuania, Poland, Romania, & Sweden (Page 1)

4. European Central Bank • The European Union is an amalgamation of 27 member states which have come together to follow common economic policies and adopt a common currency – the "euro". The European central bank is the custodian of the euro and determines, sets and monitors vital parameters such as interest rates, money supply, deficit etc for the overall  "euro zone". The Federal Banks of each specific country ( e.g. Bundesbank for Germany) negotiates with the European central bank and evolves economic policies to be followed in their specific countries such that it is consistent with the overall European central bank policy. The policies of one country may differ a little from another, e.g. Greece has recently experienced severe deficit problems and so will be allowed to pursue a more liberal policy than the other members of the European Union. • Similarities between the ECB and Federal Reserve • There are several similarities between the European Central Bank and the Federal Reserve. For instance, one important similarity is the separation of politics from the formation of monetary policy. This is all the more important for the European Central Bank as it represents several countries . This structure prevents any individual country from exerting influence or manipulating the bank for its own purposes. Another similarity worth mentioning here is that both the Federal Reserve and the European Central Bank do not hold complete autonomy. The Federal Reserve is reviewed by the Congress and the European Central Bank is reviewed by the European Parliament and the council of ministers. • Dissimilarities between the ECB and Federal Reserve • The main objective of the European Central Bank is to maintain price stability through the use of monetary policy. The acceptable target inflation rate is ‘below 2% a year’. The Federal Reserve however, is more flexible in what it defines as an acceptable inflation rate. An additional point of difference is that the European Central Bank gives more importance to transparency (i.e. making people aware of its intentions) than does the Federal Reserve. European Central Bank (ECB) vs. the Federal Reserve (Page 2)

5. Inflation • 2008 Inflation: 3.4% (Peak inflation of 4% occurred in July 2008) • 2009 Inflation: 1% • 2010 Inflation Forecast: .8% for the Euro Area, 1.2% for the EU • 2011 Inflation Forecast: 1.4% for the Euro Area, 1.7% for the EU • *Inflation figures for 2008 and 2009, as well as 2010 and 2011 forecasts obtained from Economist Intelligence Unit (EIU) • Prior to the economic downturn, inflation in the Euro Zone had increased to an annual rate above 3%, up from levels around 2% in 2005-2007. However, after the economic crisis, inflation dropped significantly with 2010 forecasts for inflation below 1%. By 2011, the economic recovery is expected to push inflation higher in the Euro Zone to a still moderate level of approximately 1.4%. • Output Growth • 2008 Output Growth: .6% • 2009 Output Growth: -4.1% • 2010 Output Growth Forecast: .9% • 2011 Output Growth Forecast: 1% • *Output Growth figures for 2008 and 2009, as well as 2010 and 2011 forecasts obtained from Economist Intelligence Unit (EIU) • From 2005 through 2007, output growth in the Euro Zone was at levels between 2% and 3%. By 2008, as the economic crisis hit, output growth dropped significantly and turned negative in 2009. Over the next two years, output growth is expected to reach moderately positive levels. However, according to EIU forecasts, total output in 2011 will still be well below 2008 levels. Economic Conditions in the Euro Zone *GDP Growth and CPI in the Euro Zone, as compared to levels in the U.S. (Page 3)

6. ECB Interest Rate History • ECB current short-term interest rate: 1% • Previous rate (prior to May 2009): 1.25% • Last meeting was on April 8, 2010. Interest rate was not changed.(This was consistent with expectations) • Inflation rate as of March 2010 is 1.5% which is the highest since December 2008 Recent Policy Stance of ECB ECB Short-Term Interest Rate (2005 – Present) Interest Rate (%) (Page 4)

7. The Taylor Rule • The Taylor Rule provides a guideline for setting the interest rate for a central bank to achieve a desired inflation rate and real GDP growth rate. • i = r* + π + a1(π –π*) + a2(y–y*) • i= target short-term interest rate • r* = equilibrium real interest rate [2%] • π = inflation rate [1.5% as of March 2010] • π* = target inflation [2%] • y = growth rate of real GDP [-4% 2010 projection based on 2009 data] • y* = target growth rate [3%] • a1= 0.5; a2= 0.5 • i = 2 + 1.5 + 0.5 (1.5 - 2.0) + 0.5 (-4 - 3) • Target interest rate: -0.25% • This suggests that the ECB should lower the current interest rate from 1%. However, given that the interest rate is the lowest it has ever been, a change is unlikely. The Taylor Rule and Its Implications for the ECB (Page 5)

8. ECB • The ECB is expected to keep short term rate steady at current level of 1% as the Greek fiscal crisis complicates its withdrawal of emergency stimulus measures. • As the Greek crisis persists, strategists have pushed back expectations for ECB rate increases until the first quarter of 2011 as seen by Bloomberg surveys. As per futures contracts, the market forecast was for the ECB to raise borrowing costs in the fourth quarter of this year. • Primary objective of ECB: • Price stabilization (clearly defines it as below but close to 2%) • At present: • ECB sees no risk of deflation • ECB predicts the euro-region economy will expand 0.8% this year after contracting 4.1% in 2009. • In march did see higher than expected inflation at 1.5%, though still less than 2% and well in the ECB’s comfort zone • Federal Reserve • Recent Fedspeak and information from the recent FOMC minutes lead us to believe that the “extended period” language for short rates will remain for sometime. • Members reiterated the expectation that economic conditions including low levels of resource utilization, subdued inflation trends, and stable inflation expectations willwarrant exceptionally low levels of the federal funds rate for an extended period. • Primary objectives of the Fed are: • Promote maximum employment • Price stability (widely believed to be 1-2% comfort zone) • Moderate long-term interest rates • At present: • Fed is currently divided on the communication of removing extraordinary monetary policy accommodation at the appropriate time. • FOMC slightly more confident on economic recovery • Do not believe inflation is a near term threat and that believes housing declines are masking inflation in other sectors Short Term Evolution of Interest Rates: ECB vs. The Fed Differences in ECB and Federal Reserve perspective • Combination of policy orientation and circumstances: • Healthier growth in the US compared to Europe • ECB members unanimously believe inflation is not a current threat, while Fed is currently divided • ECB’s policy orientation is price stability while Fed has multiple objectives and rates are set to optimize expected outcomes and minimize risk of deviating from those outcomes (Page 6)

9. Recent History • Greece has not weathered the global economic crisis well • Greece’s budget deficit and national debt exceed the limits set by the Euro countries • Greece’s credit rating has been downgraded • Current Greek 10-year bond rate: 7.40% • Current German 10-year bond rate: 3.10% • Greece has €54 billion in debt due in 2010 that it must refinance • The prospect of Greece defaulting on its debt is a threat to all countries within the Eurozone and threatens the strength of the Euro • Eurozone Countries to the Rescue • The Eurozone countries have promised €30 billion in loans to Greece over the next year • The contributions from each Eurozone country would be proportional to their GDPs, meaning Germany would contribute the largest share • The IMF may contribute up to an additional €15 billion • The rate the IMF would charge for a 3-year fixed loan would be about 5%, higher than their usual rate, but lower than the market rate for Greece • Global financial markets reacted positively to the news (Bonus): Economic Crisis in Greece (Page 7)