How is monetary policy carried out in practice?

Once a certain monetary policy has been agreed upon, it has to be put into practice. But how? Usually a central bank can implement its monetary policy strategy by supplying banks with money in exchange for safe securities and by setting the price of money, i.e. short-term interest rates which are often referred to as key monetary policy interest rates.

If the central bank raises the key interest rates, the economy cools off and inflation goes down. If the opposite happens and the central bank lowers the key interest rates, the economy picks up and inflation goes up.

The top management of a central bank meets regularly to take decisions about these monetary policy interest rates. These decisions are based on in-depth analyses of the country’s current and expected future economic development.

However, the big challenges are that monetary policy is not always immediately effective, that economic data which is crucial for decision-taking is only available with a certain time lag and that unforeseeable economic shocks might happen, which change the future path of the economy (inflation and growth).

The European Central Bank (ECB) and the national central banks (NCB) of all 19 countries currently belonging to the euro area jointly agree on the monetary policy for the whole Eurosystem.

The actual decision-making body is the Governing Council of the ECB. It consists of the ECB’s Executive Board and the governors of all euro area NCBs, which includes the Governor of the Bank of Finland. The Governing Council decides on the monetary policy for the whole euro area. It meets twice a month – usually at the ECB’s headquarters in Frankfurt, Germany and twice a year at a euro area NCB. Decisions are taken according to the “one member, one vote” principle.

Why are stable prices important?

The main and most important objective of the single monetary policy is to maintain price stability. In addition, it supports general economic policies, such as full employment and sustainable development.

Why is price stability considered to be so important that it is central to the monetary policy of the Eurosystem? Let’s look at some basics!

We speak of price stability if the value of money remains more or less the same over time. A stable currency preserves the consumers’ purchasing power; this means that a given amount of currency will buy you the same amount of goods and services today and in the future. So, purchasing power is a measure of the value of money.

But how can you talk about price stability when sometimes some prices go up while others go down? Well, a certain amount of price fluctuation is quite normal. The crucial point is that the general level of prices should not fluctuate too much over time. This means that we want to avoid both prolonged price increases (inflation) and prolonged price decreases (deflation).

How do you benefit from a stable currency?

When prices remain relatively stable, you can plan ahead without having to fear that your money will lose its value. The same is true for your family, friends, other consumers, employees and businesses: as the value of money is preserved, they all have a reliable setting for planning. So price stability is the basis for sustainable economic development.

Read more about price stability.

Inflation and deflation 

What is inflation or hyperinflation?

If the general price level rises substantially in your country, the purchasing power of your money declines – this is what we call inflation.  As a result, you and other consumers will get fewer products and services for your money. You will also notice that inflation causes your savings to lose their value.

If the price level rises very fast in a very short time we speak about hyperinflation. Estonia experienced such a hyperinflation in the 1990s, as did Poland and Russia.

What is deflation?

If the general price level decreases sustainably, we refer to this as deflation. At first glance, deflation – i.e. cheaper goods and services – might look attractive, but it can have severely negative consequences; because when people expect prices to fall further some time in the near future, they will postpone their purchases. But if everyone waits, the overall demand will drop resulting in a downward spiral of prices and an economic downturn. Businesses cannot sell their products and services anymore and are forced to lay off employees. This leaves people with less money to spend on consumption; consequently, the deflationary spiral gathers further momentum. Historic examples are the Great Depression in the 1930s or the deflation in Japan in the 1990s.

What are Eurosystem decisions based on?

On the one hand the ECB’s monetary policy strategy describes how it defines price stability and on the other hand how to analyse the risks price stability faces.

The ECB defines price stability as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below, but close to, 2% over the medium term (i.e. over a period of more or less 2–5 years).

It is always good to be well informed before taking any bigger decision. This is no different to taking sound monetary policy decisions for the euro area.

First, the ECB has to get, organize, evaluate and cross-check all relevant information before it can assess any potential risks to price stability. Then, this information is analyzed from two complementary analytical perspectives – this is what is referred to as the two-pillar approach which consists of the economic analysis and the monetary analysis. These in-depth analyses enable the ECB’s Governing Council to take its monetary policy decisions according to the principle “one member, one vote”.

Decisions are based on in-depth analyses

The broad economic analysis uses a large number of macroeconomic indicators of macroeconomic developments that serve as a basis for the assessment of the potential risks to price stability. Such indicators are, for example, salaries and wages, foreign exchange rates, long-term rates, different indicators of economic activity and fiscal policies, price and cost indices, and business and consumer barometers.

The monetary analysis uses monetary indicators to assess potential risks to price stability. Monetary indicators are, for example, the amount of notes and coins held by the public and the stock of lending of monetary financial institutions (MFIs).

This in-depth analysis enables the ECB to set its key interests at a level that is best suited to promote price stability.

After the first meeting of each month, the Council’s decisions are explained at a press conference.

How are the decisions channelled into prices?

The transmission mechanism of monetary policy is the process through which monetary policy decisions reach the economy in general and prices in particular. The mechanism is rather complex and involves a number of different actions and players. This is why it takes quite some time for the effects of a monetary policy decision to be seen on the actual price development.

Depending on the current state of a country and/or the world economy, the size and impact of such effects may vary. This also makes it difficult to make precise predictions about them. In addition, unexpected shocks, which the beyond the central bank’s control, can always affect the mechanism. These facts always have to be borne in mind by a central bank when carrying out its monetary policy.

There are a number of main transmission channels through which monetary impulses are usually transferred into the real economy. The most important one is the interest rate channel. It affects (asset) prices, savings, credit and expectations.

In addition to the interest rate channel, the exchange rate channel and the expectations channel also play a major role. The expectations channel in particular is very important for the transmission of the monetary policy. In this context “expectations” refer to what markets (government, citizens, firms and banks) believe will happen in the future and act upon this expectation.

Implementation of the Eurosystem monetary policy

ECB’s Governing Council takes the necessary monetary policy decisions for the euro area. To this end it also fixes the short-term interest rates which are usually referred to as the key interest rates thereby influencing the economy and ultimately the price level.

The Eurosystem has a set of monetary policy means or instruments at its disposal for the implementation of the monetary policy decisions. With these instruments it can influence the market interest rates, manage the supply of money to the banks and indicate its policy position or stance. In an ordinary economic environment standard instruments are sufficient. However, in an extraordinary environment, such as the crisis we have been experiencing for a few years now, unconventional or non-standard measures might become necessary.

The following sections give you an overview of the standard monetary policy instruments the Eurosystem uses to maintain the value of the euro. The two types of operation are called open market operations and standing facilities.

What are open market operations?

Open market operations are the most important of the monetary policy instruments. They are carried out on the initiative of a central bank, usually in the money market, to provide commercial banks with central bank money. There are different types of open market operations. The most important is the main refinancing operation (MRO); others are the longer-term refinancing operations (LTROs), the fine-tuning operations (FTOs) and the structural operations. They all involve transactions with different features, frequencies and maturities. Open market operations help to steer interest rates, to signal the monetary policy position and to manage liquidity.

Lending through open market operations usually takes place in the form of reverse transactions. This means that the central bank buys assets under a repurchase agreement or grants a loan against assets pledged as collateral. Reverse transactions are therefore temporary open market operations which provide funds for a limited, pre-specified period only.

What are standing facilities?

In order to control short-term interest rates in the money market and, particularly to restrict their volatility, the Eurosystem has two types of standing facilities: the marginal lending facility providing overnight liquidity, and the deposit facility absorbing overnight liquidity. Both facilities are always available for banks and have an overnight maturity and are available at the (commercial) banks’ own initiative. As the interest rates on both facilities are not as attractive as the interest rates available on the money market, credit institutions would only use them if they have no other alternative.

What are minimum reserves?

Credit institutions have to hold a certain percentage of their customers’ deposits as compulsory deposits on the accounts of their respective national central banks, in our case with the Bank of Finland.

What are unconventional or non-standard measures?

The current economic and financial crisis started back in 2008. In order to deal more efficiently with this crisis, the Eurosystem has – within its mandate – taken measures that are unprecedented in nature, scope and magnitude.  So, in addition to the conventional interest rate cuts to historically low levels, the ECB’s Governing Council decided to adopt so called non-standard measures. These measures are an extraordinary response to exceptional circumstances at a time of unusually high uncertainty and instability in the financial markets. In order to facilitate the transmission of the monetary policies and the financing of the economy the measures were mainly targeted at the banking sector.

Monetary policy is a part of economic policy

A country’s economic policy is more than just about monetary policy and setting interest rates or keeping an eye on inflation. In fact, it comprises – among others –the following key points:

exchange rate policy – this is about how a country manages the value of its currency in relation to other countries’ currencies and the foreign exchange market

financial stability – regulating and supervising the financial market as a whole as well as individual banks

fiscal policy – this includes a country’s national budget, the taxes a country sets and how it spends those taxes for the benefit of the public (revenue and expenditure, social transfers)

structural policy – is about the framework a country creates for its economy in terms of its competitiveness, its level of bureaucracy, education, the country’s overall development, research conditions, whether or not it is an attractive business location as well as moderating wage and income developments (in such a way that the country remains competitive)

While monetary and exchange rate policy are usually a central bank’s main task, other policy areas are generally fall within the responsibility of a country’s government.

Summary

The Bank of Finland is a part of the Eurosystem, which is responsible for monetary policy and other central bank tasks in the euro area and administers use of the world’s second largest currency – the euro. The primary objective of the Eurosystem and the Bank of Finland alike is price stability, which means a moderate rise in consumer prices. 

Glossary

Monetary policy

Monetary policy is pursued in order to achieve general economic policy objectives. Central banks are in charge of the practical implementation of monetary policy by managing the quantity of money in circulation as well as the interest rates or exchange rates prevailing in the markets. The Bank of Finland is part of the Eurosystem, whose main monetary policy objective is to maintain price stability and thus protect the purchasing power of the euro. The most important monetary policy tool in the euro area is the key central bank interest rate, which is decided by the Governing Council of the ECB.

Monetary policy transmission mechanism

The process through which monetary policy decisions affect the economy in general and the level of prices in particular.

Executive Board

One of the decision-making bodies of the ECB. The Executive Board comprises the President and the Vice-President of the ECB, and four other members.

Governing Council

The supreme decision-making body of the ECB. The Governing Council comprises all the members of the Executive Board of the ECB and the governors of the NCBs (national central banks) of the countries that have adopted the euro. The governors do not represent their respective countries in the Council but their own expertise.

Inflation

An increase in the general level of prices, e.g. in the consumer price index, over an extended period.

Price stability

Maintaining price stability is the primary objective of the Eurosystem. The Governing Council of the ECB has defined price stability as a year-on-year increase in the harmonised index of consumer prices (HICP) for the euro area of below 2%. It has further clarified that within this definition it aims to maintain the annual inflation rate at below, but close to, 2% over the medium term.

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