Home Forex Markets An article to understand the European Central Bank (ECB) monetary policy framework

An article to understand the European Central Bank (ECB) monetary policy framework

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An article to understand the European Central Bank (ECB) monetary policy framework


This article mainly introduces what the ECB monetary policy framework is, and how the ECB regulates the fluctuation range of the money market interest rate through the interest rate corridor, and guides the market interest rate to fluctuate around the policy interest rate.

What is the ECB Monetary Policy Framework?

Under the ECB’s current monetary policy framework, the central bank’s primary goal is to maintain inflation in the euro area below but close to 2% in the medium term, mainly through open market operations, the deposit reserve system and the interest rate corridor. to ensure that the level of money supply and short-term interest rates is consistent with the stance of monetary policy to stabilize prices.

The ECB’s open market operations mainly include the following methods: Main Refinancing Operating (MRO), Long-term Refinancing Operation (LTRO) and other temporary operations. Among them, the frequency of major refinancing operations (MRO) is once a week, and the maturity period is two weeks; the frequency of long-term financing operations (LTRO) is once a month, and the maturity period is three months.

Regarding the deposit reserve system, the European Central Bank has a unified deposit reserve requirement for all commercial banks in the euro area, and the reserve amount must be met after the daily end-of-day clearing. Borrow funds at the interest rate of the Marginal Lending Facility. For commercial banks that still have balances after liquidation, they can deposit the balance into the ECB at the interest rate of the deposit facility to obtain interest.

Since its establishment in 1998, the European Central Bank has built an interest rate corridor to regulate short-term market interest rates. , MLFR) and the deposit facility rate (Deposit Facility Rate, DFR) as the upper and lower limits to form an interest rate corridor mechanism.

How does the ECB guide market interest rates through the interest rate corridor?

The European Central Bank regulates the fluctuation range of money market interest rates through the interest rate corridor, and guides the market interest rate to fluctuate around the policy interest rate. The ECB does not set a clear target interest rate, but transmits monetary policy signals through the main refinancing operation rate (MROR), with the marginal lending rate as the upper limit and the deposit facility rate as the lower limit to build an interest rate corridor.

The ECB pays interest on the balance of commercial banks’ clearing accounts with the central bank at the deposit facility rate. Currently, the deposit facility rate is 50 basis points lower than the policy rate. At the same time, the ECB lends funds to commercial banks with insufficient reserves at the marginal lending rate. Banks, the current marginal lending rate is 25 basis points above the policy rate.

Under the current financial environment, when the market deposit rate is lower than the policy rate by 50 basis points, commercial banks are more willing to deposit funds in the central bank, and the market deposit rate will rise to the lower limit of the interest rate corridor; when the market loan rate is higher than the policy rate by 25 basis points 1 basis point, commercial banks are willing to borrow funds from the central bank, and the market lending rate falls back to the upper limit of the interest rate corridor. Through such a mechanism, the central bank can regulate market interest rates to fluctuate within the range of the interest rate corridor.

In Figure 1, we can see that the ECB interest rate corridor was asymmetric at the very beginning, with the marginal lending facility rate 150 basis points higher than the policy rate, and the deposit facility rate 100 basis points lower than the policy rate. The range narrowed to 200 basis points until October 2008, when the ECB further narrowed the corridor to 100 basis points in response to the financial crisis.

By July 11, 2014, the European Central Bank lowered the deposit facility interest rate to -0.1, and the central bank officially implemented a “floor” interest rate corridor, which lasted until July this year. The European Central Bank raised interest rates for the first time since July 2011. The interest rate corridor range of 75 basis points.

(by Chris Li)

Follow me on Twitter for more exchanges: @ChrisLi865

References:

https://www.reuters.com/article/idCNL3S0UF1UQ20141231

https://www.ecb.europa.eu/stats/policy_and_exchange_rates/key_ecb_interest_rates/html/index.en.html

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