The European Central Bank's approach to transparency and credibility in monetary policy

Monetary Policy of the ECB

MONETARY POLICY of the EUROPEAN CENTRAL BANK

ITEM NO.

ITEM TITLE PAGE NO.

Price Stability

Role of Monetary Policy

ECB Basic

Current Best Practice: Predictability

Interest Rates

Optimal Monetary Policy Rule

ECB Credibility

Legislative Powers of the ECB

Interest Rate 'Smoothing' Practice of ECB

Communication of Monetary Policy Critically Important

OECD's Recommendations for the ECB (January, 2007)

MONETARY POLICY of the EUROPEAN CENTRAL BANK

FIGURE NO.

FIGURE TITLE

Figure 1 Primary Transmission Channels of Monetary Policy Decisions

Figure 2 the Decision-Making Bodies of the ECB

Figure 3 Average number of trades per minutes, on press conference days compared with Thursdays without Governing Council Meetings 1999- 2006

Figure 4 Decomposition of changes in the money market yield curve on Governing Council Meeting Days

Figure 5 Market reaction of euro area interest rates to speeches and interviews by Governing Council members 1999-2004

Figure 6 Central Bank Balance Sheet Structure

Figure 7 Contributions to the Banking System's Liquidity

Figure 8 Volume of the Main and Longer-Term Refinancing Operations

Figure 9 Require Reserves and Autonomous Liquidity Factors

Figure 10 Estimates of responses of real GDP and consumer prices to a one- percentage point increase in the policy-controlled interest rate in the euro area

MONETARY POLICY of the EUROPEAN CENTRAL BANK

ABSTRACT

The monetary policy of the European Central Bank (ECB) is one that is optimally transparent and clearly communicated to the public so as to avoid any misunderstandings and as well to avoid any shock effect to the economy due to shifting changes in the interest rates. It is critically necessary that the monetary policy of the central bank be one that is characterized by stability, credibility, and predictability. In fact, the word "boring" has been used to describe the activities of the central bank in that the central banking function is one of an extremely uneventful nature in the optimal sense. The primary objective of the ECB monetary policy is "to maintain price stability" which is set out in the Treaty establishing the European Community. The operation framework of the ECB follows the guiding principles of: (1) operational efficiency; (2) equal treatment and harmonization; (3) decentralized implementation; and (4) simplicity, transparency, continuity, safety and cost efficiency." (ECB, 2007)

MONETARY POLICY of the EUROPEAN CENTRAL BANK

EXECUTIVE SUMMARY

Primary among the concerns of monetary authorities is stability in the financial sector and history speaks clearly of monetary instability brought on by the financial sector. The Great Depression is one example of this principle. When depositors lack trust in the bank withdrawals of money may result in a 'run on a bank', which results in bank's inability to produce all the monies being called in by depositors. In the case where several various banks simultaneously bankrupt recession of a serious nature is likely. Fortunately, the central bank's provision of deposit insurance and liquidity support work toward the prevention of such occurrences. The European Central Bank is stated to play a role relating to responsibility for ensuring financial stability in the majority of EU countries. (Goodhart and Schoenmaker, 1995) the work of Eijffinger (2001) entitled: "Evaluation of the Economic Situation in Europe - 2nd Quarter 2001 (May 2001) for the European Parliament: Should the European Central Bank Ben Entrusted with Banking Supervision in Europe?" states: "The ECB is not entrusted with any direct responsibility related to prudential supervision of credit institution and the stability of the financial system. These functions are in the realm of the competent national authorities. (Eijffinger, 2001) in a study presented at the Royal economic Society's Annual Conference the question is asked as to why the ECB has "such a poor reputation for transparency, when money market dealers have no problem in understanding what is going on - and why the Bundesbank was regarded as a model of successful central banking when it revealed so little of its thinking? In recent years, we have seen an emerging consensus that central banks should be not just independent of governments, but also 'transparent' and open in their conduct of policy." (Why the European Central Bank's Monetary Policy Seems Less Transparent, nd) as a matter of fact, Central Banking should be quite dull according to Bank of England Governor Mervyn King who states specifically of Central Banking that is should be extremely boring. First it is stated that criticism is widely spread of the ECB relating to the sending of 'confused messages' and additionally stated is a "...paradox. When it comes to transparency, the acid test is whether or not people can anticipate on average what the central bank is going to do." (Why the European Central Bank's Monetary Policy Seems Less Transparent, nd)

MONETARY POLICY of the EUROPEAN CENTRAL BANK

INTRODUCTION

According to the European Central Bank the objective of monetary policy is "to maintain price stability" which is set out in the Treaty establishing the European Community. Stated is: "Without prejudice to the objective of price stability" the Eurosystem will also "support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community." (ECB, 2007) This is to include a "high level of employment" as well as "sustainable and non-inflationary growth." (ECB, 2007) the provisions of the Treaty illustrate the consensus that: (1) the benefits of price stability are of a substantial nature; and (2) the natural role of the monetary policy in the economy is to maintain price stability. (ECB, 2007; paraphrased)

LITERATURE REVIEW

I. PRICE STABILITY

The definition of price stability has been assigned by the ECB Governing Council as follows: "Price stability is defined as a year-on-year increase in the Harmonized Index of Consumer Prices (HICP) for the euro are of below 2%." (ECB, 2007) the benefits of price stability are listed as: (1) Makes the monetary policy more transparent; (2) Provides a clear and measurable yardstick against which the European citizens can hold the ECB accountable; and (3) Provides guidance to the public for forming expectations of future price developments. (ECB, 2007) the reasons that the ECB aims for 2% year-to-year increases are stated to be because "it also underlines the ECB's commitment to: (1) Provide an adequate margin to avoid the risks of deflation. Having such a safety margin against deflation is important because nominal interest rates cannot fall below zero. In a deflationary environment, monetary policy may thus not be able to sufficiently stimulate aggregate demand by using its interest rate instrument. This makes it more difficult for monetary policy to fight deflation than to fight inflation; (2) Take into account the possibility of HICP inflation slightly overstating true inflation as a result of a small but positive bias in the measurement of price level changes using the HICP; and (3) Provide a sufficient margin to address the implications of inflation differentials in the euro area. It avoids that individual countries in the euro area have to structurally live with too low inflation rates or even deflation." (ECB, 2007)

II. ROLE of MONETARY POLICY

The ECB is "the sole issuer of banknotes and bank reserves..." meaning it is the "monopoly supplier of the monetary base." (ECB, 2007) Because of the monopoly of the ECB, the ECB is able to make the conditions at which the banks are enabled to borrow from the central bank and as well is able to influence the conditions under which trade between banks take place in the money market. Stated is: "Ultimately the change will influence developments in economic variables such as output or prices. This process - also known as the monetary policy 'transmission mechanism' - is highly complex. While its broad features are understood, there is no consensus on its detailed functioning." (ECB, 2007) Inflation is "monetary phenomenon." High monetary growth is generally associated with long periods of high inflation. Since the ECB is the monopoly supplier of the monetary base, which consists of:

1) Currency (banknotes and coins);

2) the reserves held by counterparties with the Eurosystem; and 3) Recourse by credit institutions to the Eurosystem's deposit facility." (ECB, 2007)

The central bank is able to signal its monetary policy stance to the money market through changing the conditions that the central bank is willing to enter into transactions with institutions of credit. Furthermore, the central bank as well aims to make sure of the money market's proper functioning and assist credit unions in meeting needs in liquidity through provision of regular financing to credit institutions and allowing these institutions to deal with "end-of-day balances and to cushion transitory liquidity fluctuations." (ECB, 2007) the operational framework of the Eurosystem is stated to be "based on the principles laid down in the Treaty on the European Union specifically Article 105 of the treaty which states that in achieving its objectives the Eurosystem "...shall act in accordance with the principle of an open market economy with free competition, favoring an efficient allocation of resources..." (ECB, 2007) the operational framework also followed several guiding principles which are those of: (1) Operational efficiency; (2) Equal treatment and harmonization; (3) Decentralized implementation; and (4) Simplicity, transparency, continuity, safety and cost efficiency." (ECB, 2007)

Operational efficiency is held to be the most important of all the principles of operation for the ECB and can be defined as "the capacity of the operational framework to enable monetary policy decision to feed through as precisely and as fast as possible to short-term money market rates. These in turn, through the monetary policy transmission mechanism, affect the price level." (ECB, 2007) Equal treatment and harmonization is a principle that holds that credit institutions must be treated equally regardless of their size or their location in the euro area. Simplicity and transparency are said to "ensure the intentions behind monetary policy operations are correctly understood. The principle of continuity aims at avoiding major changes in instruments and procedures, so that central banks and their counterparties can draw on experience when participating in monetary policy operations. The principle of safety requires that the Eurosystem's financial and operational risks are kept to a minimum. Cost efficiency means keeping low the operational costs to both the Eurosystem and its counterparties arising from the operational framework." (ECB, 2007) the following chart illustrates the primary transmission channels of monetary policy decisions.

Primary Transmission Channels of Monetary Policy Decisions

Source: ECB (2007)

Change in official interest rates takes place through the central bank providing funding to the banking systems and charging interest. The central bank can make full determination of this interest rate due to its monopoly power of issuance of money. The affects to banks and money-market interest rates is one of a direct nature in terms of money-market interest rates and of an indirect nature in terms of lending and deposit rates which the banks themselves set for customers. In terms of expectations of future official interest-rate changes and the affect on medium and long-term interest rates specifically, the longer-term interest rates are dependent, at least in part, on the expectations of the market concerning short-term rates future course. Also guided by monetary policy can be the economic agents' expectations related to future inflation and this has an influence on developments in prices. If the central bank has credibility of a high nature then it is able to firmly anchor price stability expectations and this enables economic agents to avoid increase of prices in anticipation of higher inflation and reduces the fear associated with deflation. In terms of the effect on asset, prices it is stated that: "The impact on financing conditions in the economy and on market expectations triggered by monetary policy actions may lead to adjustments in asset prices (e.g. stock market prices) and the exchange rate. Changes in the exchange rate can affect inflation directly, insofar as imported goods are directly used in consumption, but they may also work through other channels." (ECB, 2007) the impact of changes in interest rates are illustrated in the decision of households and firms. Consumption and investment are also affected by changes in asset prices via wealth effects and effects on collateral value. The example given is: "...as equity prices rise, share-owning households become wealthier and may choose to increase their consumption. Conversely, when equity prices fall, households may reduce consumption. Asset prices can also have impact on aggregate demand via the value of collateral that allows borrowers to get more loans and/or to reduce the risk premium demanded by lenders/banks." (ECB, 2007) the effect to the supply of credit is that higher interest rates bring on an increase in the risk that borrowers will not be able to pay back their loans and thus the bank is likely to cut back on the funds that are loaned to households as well as to firms. Changes in aggregate demand and prices are affected by changes in consumption and investment, which in turns changes the "level of domestic demand for goods and services relative to domestic supply." (ECB, 2007) it is related that when supply is exceeded by demand that "upward pressure is likely to occur..." As well as "changes in aggregate demand may translate into tighter or looser conditions in labor and intermediate product markets. This is turn can affect price and wage-setting in the respective market." (ECB, 2007)

III. ECB BASIC TASKS

The basic tasks of the Eurosystem are: (1) Definition and implementation of the monetary policy in the euro area; (2) the conduct of foreign exchange operations; (3) the holding and management of the official foreign reserves of the member states; and (4) the promotion of the smooth operation of payment systems." (the Monetary Policy of the ECB, 2004) the following illustrates the decision-making bodies of the ECB.

The Decision-Making Bodies of the ECB

Source: The Monetary Policy of the ECB, 2004

The Governing Council of the ECB is stated to "consists of the six members of the Executive Board the governors of the euro areas NCBs (12 governors as of 2003). " (the Monetary Policy of the ECB, 2004) the President of the ECB chairs both the Governing Council and the Executive Board and when absent the Vice-President fills this role. The responsibilities of the Governing Council are: (1) the adoption f the guidelines and taking the necessary decisions for ensuring the performance of the tasks entrusted to the Eurosystem; and (2) the formulation of the monetary policy of the euro area. (the Monetary Policy of the ECB, 2004; paraphrased) the Executive Board of the ECB is comprised of the President and Vice-President as well as four other members all of which are appointed by the Head or State of Government for the euro area countries. The Executive Board is responsible for: (1) preparing the meetings of the Governing Council; (2) implementation of monetary policy in accordance with the guidelines and decisions laid down by the Governing Council; (3) the current ECB business; and (4) assuming certain power delegated to it by the Governing Council, which may include power of a regulatory nature. (the Monetary Policy of the ECB, 2004; paraphrased) the General Council of the ECB is comprised of the President and Vice-President of the ECB and the governors of the NCBs of all EU Member States. The General Council does not have any responsibility for monetary policy decisions in the Euro area. The central bank is independent from political influence due to the institutional framework for the single monetary policy. Stated is: "A large body of theoretical analysis, supported by substantial empirical evidence, indicates that central bank independence is conducive to maintaining price flexibility." (the Monetary Policy of the ECB, 2004) the important principles of central bank independence are laid out in Article 108 of the Treaty. While exercising the powers and carrying out tasks and duties appointed them, "neither the ECB nor the NCBs, nor any member of their decision making bodies are allowed to seek or take instructions from Community institutions or bodies, from any government of a Member Sate or from any other body." (the Monetary Policy of the ECB, 2004) Furthermore, this principle must be respected by Community institutions, bodies, and governments of Member States who must not "seek to influence the members of the decision-making bodies of the ECB." (the Monetary Policy of the ECB, 2004) Other safeguards include the fact that the ECB's financial arrangements are separately kept from those of the European Community." (the Monetary Policy of the ECB, 2004) Another safeguard is through the ECB having its own budget with the "...capital subscribed and paid up by the euro area NCBs." (the Monetary Policy of the ECB, 2004)

IV. CURRENT BEST PRACTICE: PREDICTABILITY he work entitled: "The Predictability of the ECB's Monetary Policy" states that: "Current best practice in monetary policymaking, as embodied in the monetary policy framework of the ECB, emphasizes the desirability of a high level of predictability in central bank decisions. A distinction can be made between the notions of short-term and longer-term predictability. Short-term predictability is achieved when the public is in a position to anticipate correctly the central bank's next monetary policy decisions. A more fundamental aspect of monetary policy predictability relates to its longer-term dimension, which requires that the public has a genuine understanding of the central bank's monetary policy framework and its behavior over time. A high degree of predictability of interest rate decisions is the result of monetary policy being conducted in a credible and transparent manner that is well explained to the public. Hence, while predictability broadly understood is not an objective per se, it enhances the effectiveness of monetary policy and contributes to accountability vis-a-vis the public at large." (nd) Predictability is said to reduce uncertainty concerning interest rates and results in the facilitation of asset pricing as well as lowering the risk thereby contributing to the market allocation efficiency and allows better management of the balance sheets of firms and reducing the vulnerability of the firms to economic shocks, lowering risk management costs and creating the necessary conditions for good investment decisions. Comprehension of the strategy of the monetary policy by members of the public assist in price-guiding and setting of wages in a manner that is consistent with the central bank objectives. This is only able to be achieved through "consistent and credible implementation of the central bank's monetary strategy." (the Predictability of the ECB's Monetary Policy, nd) Stated is that: "A coherent track record of reliable policymaking is clearly indispensable for ensuring that the public understands the behavior of the central bank." (the Predictability of the ECB's Monetary Policy, nd)

V. INTEREST RATES

The Governing Council of the ECB sets the key interests rates, which determine the stance of the ECB's monetary policy. The three key interest rates for the euro area are: (1) the interest rate on the main refinancing operation (MRO) which provide the bulk of liquidity to the banking system; (2) the rate on the deposit facility, which banks may use to make overnight deposits with the Eurosystem; and (3) the rate on the marginal lending facility, which offers overnight credit to banks from the Eurosystem." (Monetary Policy Decisions, 2007)

VI. OPTIMAL MONETARY POLICY RULE

The work of Paolo Gelain entitled: "The Optimal Monetary Policy Rule for the European Central Bank" states that Article 105 of the Maastricht Treaty of 1992 established quite clearly the aim of the European Central Bank in the statement that "the primary objectives of the ESCB is to maintain price stability. Without prejudice to this objective, it shall support the general economic policies in the Community with a view to contributing to the achievement of the objective of the Community. Furthermore the ESCA shall act in line with the principle of an open market economy with free competition." (Gelain, nd) Gelain states that the ECB has been charged by the responsibility of the maintenance of the price stability, but at the same time it has to care about other objectives, like economic growth.." (nd) an implication exists that the ECB "works in a regime of inflation targeting. As a matter of fact definition of inflation targeting is not unique since many give different and sometimes conflicting definitions, but there are some criteria which one has to look for to define inflation targeting." (Gelain, nd)

Gelain points out the states of Mishkin (2001) who stated that: "...inflation targeting is a recent monetary policy strategy that encompasses five main elements;

1) the public announcement of medium-term numerical targets for inflation;

2) an institutional commitment to price stability as the primary goal of monetary policy, to which other goals are subordinated;

3) an information inclusive strategy in which many variables [among which inflation may have an important role];

4) Increase transparency of the monetary policy strategy through communication with the public and the markets about the plans, objectives, and decisions of the monetary authorities; and 5) Increased accountability of the central bank for attaining its inflation objectives." (Gelain, nd)

Gelain states that what is reported in the end of the work is the "concrete monetary-policy of the ECB. The ECB controls the liquidity of the Eurosystem through short-term reverse-repo operations. Every week, the ECB opens a call for tenders for the Euro-zone counterparts (banks and other financial institutions). It then lends cash to banks for a two-week period. Banks are asked to inform the ECB about the interest rate they want to pay for every euro they borrow, knowing that those who pay the higher price will be first served. The ECB sets a downward limit on interest rates, by fixing a minimum bid rate. This is the main monetary policy instrument in the Euro-zone. So far, bids from commercial banks do not diverge much from this minimum rate." (Gelain, nd)

VII. ECB CREDIBILITY

The work of Ugo Marini entitled: "The Monetary Policy of the European Central Bank and the Euro-Dollar Exchange Rate" reports research conducted in order to evaluate the exchange rate of the Euro after the first six months of its existence." (nd) the fact is that the exchange rate of the Euro is connected with policy issues. Marani states that: "In principle the role of the Council of formulating general orientations for exchange rate policy may lead to conflicts about desirable monetary policies." (nd) it is related that in the hypothesis: "...of a connection between ECB monetary policy and the evolution of the Euro exchange rate can be stated if we assume that, at the present, the ECB is the principal agent responsible of the management of the Euro and that the ECB will give, in future, a stringent interpretation of the Maastricht Treaty; accepting general orientations by the Council only if they are strictly consistent with the control of the monetary aggregates. The conclusion is that we can study the effects of ECB conduct on the Euro value excluding the probabilities of 'external political pressures'." (nd) in the initiative to understand the actual strategy of the ECB as related to the principal propositions within mainstream analysis required will be to start from the base issue of monetary policy time consistency. In this endeavor, Marani states that it is useful to bring to mind the primary conclusions "reached by the convention framework moving from the time-consistency constraint" as follows:

The central bank credibility is founded on policies that are consistent with earlier plans and announcements and, hence, on the ability to precommit to policies;

This commitment implies the preference for a rule instead of discretionary policies that is the only way to achieve the 'minimum' inflation rate;

The rate of inflation is minimized because the rule avoids the insurgence of an inflationary bias, that arises from the central bank's desire for an unemployment rate below the natural rate joined with its inability to credibly commit to a low inflation rate;

The rules and the elimination of the 'inflation bias' determine the reputation and the credibility of the central banker that would be lost if he deviates from the 'minimum inflation' solution;

The reputation of the central bank is safer if its preferences differ from those of the elected government; hence it is optimal that the government appoints a central banker who places greater relative weight on the inflation objective than does society as a whole; and This kind of appointment defends the independence of central bank and grants a lower average inflation and a greater real economy performance." (Marani, nd)

Marani states that the most confounding issues is "the concept of credibility" because "the notion of credibility included is the benchmark model is strictly connected with the time consistency which arises from the belief in a systematic inflationary bias in the behavior of the central bank." (Marani, nd; paraphrased) This belief is not supported either in theory or in practice. Furthermore, when investigating the issue of credibility findings in literature show that the idea is "related to a 'precommittment' and/or 'strong aversion to inflation': the loss of reputation, hence, arises if the central bank deviates from the low-inflation solution." (Marani, nd) Credibility is held in the work of Blinder to be based upon the belief of people that the bank will do what it says it will do. (Marani, nd) in other words, credibility and reputation of the bank is dependent upon more "complex and perhaps, cogent conditions such as: (1) the referral to the specific model of the working of the monetary policy when the central bank announces its final targets; (2) the implementation of measure consistent with the underlying model; (3) the public's subjective confidence that the goals could be, in principle, achieved." (Marani, nd)

Marani states that it is possible to state that the condition (when considering the first semester of ECB conduct was: (1) perhaps satisfied; (2) partially satisfied; (3) unsatisfied." (nd) Marani states that the: "...choice of monetary targeting, within a framework of tight monetary stance, has the outcome of a gradual reducing of the price increases without the definition of a lower bond for the inflation rate. Marani writes that Keynes was the first to comprehend the problem's relevance as follows: "If the reduction of money wages is expected to be a reduction relatively to money-wages in the future, the change will be favorable to investment, because...it will increase the marginal efficiency of capital; whilst for the same reason it may be favorable to consumption. if, on the other hand, the reduction leads to an expectation, or even to the serious possibility, of a further wage-reduction in prospect, it will have precisely the opposite effect. For it will diminish the marginal efficiency of capital and will lead to the postponement of investment and of consumption." Marani states that the expectations and confidence of agents' are twofold as follows: (1) central bank credibility is itself an important part of the transmission mechanism of monetary policy; and (2) a central bank must be aware of all the possible effects of its strategy on markets expectations." (Marani, nd) the Eurosystem monetary instruments are stated to be those as follows:

Open market operations;

Standing facilities; and Minimum reserves. (Marani, nd)

Open market operations are stated to play a role that is very important specifically relating to the monetary policy of the Eurosystem for the purposes of: "...steering interest rates, managing the liquidity situation in the market and signaling the stance of monetary policy."(Marani, nd) Five types of instruments are stated to be available to the Eurosystem for the conduction of open market operations, which are those as follows:

Reverse transaction (applicable on the basis of repurchase agreements or collateralized loans) "Reverse transactions refer to operations where the Eurosystem buys or sells eligible assets under repurchase agreements or conducts credit operations against eligible assets provided as collateral. Reverse transactions are used for the main refinancing operations and the longer-term refinancing operation. In addition the Eurosystem can use reverse transactions fro structural and fine-tuning operations." (the Monetary Policy of the ECB, 2004)

Outright transactions: These transactions refer to the operations "...where the Eurosystem buys or sells eligible assets outright on the market. Outright open market operations are only available for structural and fine-tuning purposes." (the Monetary Policy of the ECB, 2004)

Issuance of debt certificates: The ECB "...may issue debt certificates for the purpose of adjusting the structural position of the Eurosystem vis-a-vis the financial sector so as to crate or increase a liquidity shortage in the market." (the Monetary Policy of the ECB, 2004)

Foreign exchange swaps: These are executed for various purposes and consist of "simultaneous spot and forward transactions in euro against a foreign currency. They can be used for fine-tuning purposes, mainly in order to manage the liquidity situation in the market and to steer interest rates." (the Monetary Policy of the ECB, 2004)

Fixed-term deposits: Counterparties may be invited by the Eurosystem to place "remunerated fixed-term deposits with the ECB in the Member State in which the counterparty is established. The collection of fixed-term deposits is envisaged only for fine-tuning purposes in order to absorb liquidity in the market." (the Monetary Policy of the ECB, 2004)

Open market operations are stated to be: "...initiated by the ECB which also decides on the instruments to be used and the terms and conditions for their execution. They can be executed on the basis of standard tenders, quick tenders or bilateral procedures. The Eurosystem's open market operation is categorized into the following four: (1) the main refinancing operations: "(regular liquidity-providing reverse transactions with a weekly frequency and a maturity of normally one week. These operations are executed by the national central banks on the basis of standard tenders. The main refinancing operations play a pivotal role in pursuing the purposes of the Eurosystem's open market operations and provide the bulk of refinancing to the financial sector"; (Marani, nd) (2) the longer-term refinancing operations" are liquidity-providing reverse transactions with a monthly frequency and a maturity of normally three months. These operations aim to provide counterparties with additional longer-term refinancing and are executed by the national central banks on the basis of standard tenders. In these operations, the Eurosystem does not, as a rule, intend to send signals to the market and therefore normally acts as a rate taker" (Marani, nd); (3) Fine-tuning operations" are executed on an ad hoc basis with the aim of managing the liquidity situation in the market and steering interest rates, in particular in order to smooth the effects on interest rates caused by unexpected liquidity fluctuations in the market. Fine-tuning operations are primarily executed as reverse transactions, but can also take the form of outright transactions, foreign exchange swaps and the collection of fixed-term deposits. The instruments and procedures applied in the conduct of fine-tuning operations are adapted to the types of transactions and the specific objectives pursued in the operations. Fine-tuning operations are normally executed by the national central banks through quick tenders or bilateral procedures. The Governing Council of the ECB will decide whether, under exceptional circumstances, fine-tuning bilateral operations may be executed by the ECB itself"; (Marani, nd) and (4) Structural operations may be carried out by the Eurosystem "through the issuance of debt certificates, reverse transactions and outright transactions. These operations are executed whenever the ECB wishes to adjust the structural position of the Eurosystem vis-a-vis the financial sector (on a regular or non-regular basis). Structural operations in the form of reverse transactions and the issuance of debt instruments are carried out by the national central banks through standard tenders. Structural operations in the form of outright transactions are executed through bilateral procedures." (Marani, nd)

IX. INTEREST RATE 'SMOOTHING' PRACTICE of ECB

The article entitled: "Monetary Policy 'Activism'" published in the ECB Monthly Bulletin November 2006 relates several theoretical arguments presented by central banks related to the practice of 'interest rate smoothing'. The arguments reviewed are those as follows: (1) Learning processes: Brainard (1967) "established that uncertainty about true values of the parameters of the model economy should have the effect o f attenuating the response of the policy instrument to shocks, as the central bank tries to minimize the variance of macroeconomic outcomes. (ECB Monthly Bulletin November, 2006); (2) Credibility losses: Ellis and Lowe (1997) formalized this monetary policy "in the context of asymmetric information between the central bank and the public. If the central bank has imperfect knowledge about the details of the model governing the economy and/or the public thinks that the central bank is not perfectly informed about current economic developments, frequent alterations in the path of policy rates could possibly cast some doubt on the central bank's ability to understand how the economy works." (ECB Monthly Bulletin November, 2006); (3) Disruptions in the capital market: Cukierman (1989) made the observation that "standard loan contracts extended by commercial banks are characterized by long maturities and predetermined interest rates. However, standard deposit contracts habitually exhibit short-term maturities and, therefore, react quickly to nominal interest rate changes and unanticipated credit or money demand shocks. For this reason, interest rate inertia protects the banking system to some extent against negative shocks to cash flows on the banks' liability side. This mechanism could limit the risk of widespread bank insolvencies and it would help to prevent undue stress in financial markets resulting from monetary policy decisions." (ECB Monthly Bulletin November, 2006); (4) Overcoming the stabilization bias: Woodford (2003) the monetary authority might experience more success in economy stabilization through a commitment to adjusting policy rates in form of 'inertia' which would "...strengthen the ability of the central bank to affect expectations of future interest rates and thereby to stabilize inflation and output more effectively." (ECB Monthly Bulletin November, 2006) the example provided is one stating an assumption that inflationary shock is negative affecting the economy. "If agents anticipate a protracted policy rate increase as part of the central bank's reaction, expectations of persistently higher short-term rates in the future would boost the market rates on long-term securities, as these can be roughly thought of as averages of the short-term rates that are expected to prevail until these securities reach maturity. Since medium and long-term rates are regarded as more important determinants of the conditions at which the private sector can borrow to finance spending (Goodfriend, 1991; Tinsley, 1999), higher rates on instruments with longer maturities can be expected to exert a dampening impact on aggregate demand. As a consequence, inflation expectations would also be dampened and the inflationary effects of the initial perturbation would be mitigated by the absence of second round effects. In other words, the inertial rule suppresses a temporary increase in inflation via two channels: an increase in the current policy rate and lower inflation expectations due to the rise in expected future policy rates. Consequently, a monetary policy able to implement an "optimal degree" of inertia would achieve a better trade-off between inflation stabilization and output-gap stabilization, as the need to make large adjustments in the policy rate would be reduced.."(ECB Monthly Bulletin November, 2006); (5) the zero lower bound on nominal interest rates: Rotemberg and Woodford (1999) the zero lower bound on nominal interest rates: Rotemberg and Woodford (1999) noted that in a "forward looking framework, the zero bound on nominal rates generates additional incentives to keep the variance of policy rates low, especially in a low inflation environment. Nominal interest rate inertia would make it easier to deal with the zero bound problem because, as mentioned above, an inertial monetary policy would make relatively large shifts in the policy rate unnecessary in environments in which agents were sufficiently forward-looking. Reifschneider and Williams (2000) and Wolman (2005) built on this concept and found that, once the policy rate had reached its lower bound, a protracted inertial monetary policy could be counted upon to exert downward pressure on longer-term rates via the expectations theory of the term structure and could thus decisively mitigate the adverse effects of the zero lower bound of the short-term nominal rate." (ECB Monthly Bulletin November, 2006) it is concluded in this work that the appropriate degree of central bank activism is dependent upon the adjustment to "outside disturbances required by the central bank's objective. The associated monetary policy patterns hinges upon the structural characteristics of the economy and the sequence, nature and size of the shocks to which the central bank has to respond." (ECB Monthly Bulletin, November, 2006) Additionally stated is that the determination of the ECB in maintenance of price stability "over the medium term and ensuring the anchoring of long-term inflation expectations has as a consequence created an environment more favorable to output growth and job creation in the euro area." (ECB Monthly Bulletin, November, 2006) Stated as a "challenges for the euro area" is the acceleration of structural reform implementation for enhancement of competitive and flexible labor and product markets, which will facilitate growth and productivity as well as bring improvement to supply-side development. Such reforms are stated to have the capacity to "prepare the ground for solid growth in economic activity" as well as "...improve the macroeconomic environment faced by monetary policy." (ECB Monthly Bulletin, November, 2006)

X. COMMUNICATION of MONETARY POLICY CRITICALLY IMPORTANT

The article entitled: "Communicating Monetary Policy to Financial Markets" states that communication "is fundamental to central bank transparency" and the trend most recently of central bank independence on a global basis is the preference for transparency and openness which:."..can enhance the effectiveness of monetary policy." (ECB Monthly Bulletin April 2007) Because of this central banks are focusing toward more effective communication with the public. Stated as the primary need is for central banks to establish a consistency "between words and deeds." (ECB Monthly Bulletin April 2007) in this article the effects of communication are discussed against a conceptual background and stated is that the transparency of the central bank and its "main instruments, communication are important for the effectiveness, credibility and also for the predictability of monetary policy. Modern central banks employ a variety of communication channels, such as press conferences, bulletins, speeches or minutes, that aim to enhance the transparency, and hence also the effectiveness, of monetary policy within a well defined communication strategy." (ECB Monthly Bulletin April 2007) in other words, there is no excuse for failure to effectively communicate to the public. According to this work monetary policy is more effective when transparent for two primary reasons: (1) clarity about its mandate and the means of pursuing it helps a central bank to foster credibility; (2) transparency helps market participants to understand the systematic response pattern of monetary policy to economic developments and shocks, thereby making policy decisions more predictable." (ECB Monthly Bulletin April 2007) the reason that this predictability is so greatly desired for the central bank is because there is a reduction in the level of uncertainty concerning interest rates and this factors "facilitates the pricing of assets." (ECB Monthly Bulletin April 2007) Because longer-term predictability includes the capacity of the financial market participants as well as the public to comprehend the framework of the monetary policy, transparency is a more credible strategy in monetary policy. This article notes that credibility being vested in the central bank results in a "more immediate transmission of monetary policy intentions to investment and consumption decisions and thus accelerate the necessary economic adjustments." (ECB Monthly Bulletin April 2007) This leads to the importance of communication of the monetary policy strategy in order to achieve this level of 'desired' longer-term predictability. This is accomplished in a transparent and credible manner in that the objective is well communicated and is supportive of the "markets' understanding of the systematic response of monetary policy to the changing economic developments." (ECB Monthly Bulletin April 2007) if the central bank lacks the proper guidance in strategic formation of the objective of monetary policy the risk is that: "...market participants adjust their longer-term expectations as a mere reflection of current circumstances." (ECB Monthly Bulletin April 2007) Stated is that the central banks: "...ultimate objective and the strategy which governs its behavior in the race of risks that might threaten the achievement of that objective minimizes the sensitivity of expectations to short-term shocks. Long-term inflation expectations will remain in line with the central bank's objective and this, in turn, will facilitate the conduct of monetary policy." (ECB Monthly Bulletin April 2007) Empirical evidence is stated to exist that supports the effects of communication on the monetary policy of the ECB. Stated specifically is: "There is compelling empirical evidence that inflation expectations are indeed affected by the announcement of a quantitative definition of price stability, lending support to the idea that a clear and transparent objective can serve as a focal point for agents' inflation expectations. Central banks have established a good track record in that regard. In fact, empirical findings confirm that the precise definition of price stability, or the announcement of an inflation target, lowers inflation expectations. Moreover, inflation expectations are no longer correlated with past inflation and, at the same time, tend not to react to macroeconomic news. The empirical evidence thus clearly suggests that a clear and transparent objective helps to anchor inflation expectations at levels consistent with the central bank's definition of price stability." (ECB Monthly Bulletin April 2007)

Average number of trades per minutes, on press conference days compared with Thursdays without Governing Council Meetings 1999-2006

ECB Monthly Bulletin April 2007

The foregoing chart shows the trading activity "on a number of futures markets in a time window with a range from 13:00 to 16:00 on the days of the monthly press conference cited by the blue line and on Thursdays. Trading rises in what is called a 'marked response' to the monetary policy decision announcement and in the time window just after the press conference. This seems to suggest that the "decision and the related communication provides news to financial markets." (ECB Monthly Bulletin April 2007) the article states as follows:

This indication is corroborated if one separates "jump news" and "path news" contained in the ECB's communication on Governing Council meeting days, as can be seen in Chart 2. Jump news indicates the degree to which a given monetary policy decision has led to financial market reactions, based on changes in the short end of the money market yield curve (around one month out). A positive (negative) indicator in Chart 2 implies that short-term money market rates were increasing (decreasing) on Governing Council meeting days; the size of the indicator corresponds to the magnitude of the market reaction. Path news, instead, is based on changes in the medium-term segment of the money market yield curve (at a time horizon of about half a year or more), which are unexplained by changes in expectations at short horizons. Such changes reflect revisions of the expected path of monetary policy in the medium term. Interestingly, the path news is closely related to market movements during the ECB press conference, suggesting that the communication surrounding the announcement of the decision may result in significant changes in market expectations regarding the path of monetary policy. Chart 2 clearly indicates that surprises about monetary policy decisions, as proxied by the jump news, have considerably decreased over time, thus leaving a larger role for the forward-looking part of the communication. This evidence suggests that financial markets react to the ECB press conference. As the press conference targets the general media in addition to financial markets and financial newswire services, an interesting question relates to how it is reflected in the media, in particular because this allows the ECB communication to reach a wider audience. Quantitative analysis of press reporting in response to the ECB press conference based on a sample of 57 international and national newspapers shows that, on average, reporting is extensive, yet subject to substantial variation. Most of the variation in the reporting is found over time, and can be explained by the characteristics of the monetary policy decision, market expectations and reactions as well as the macroeconomic environment." (ECB Monthly Bulletin April 2007)

Decomposition of changes in the money market yield curve on Governing Council Meeting Days.

Source: ECB Monthly Bulletin April 2007

Market reaction of euro area interest rates to speeches and interviews by Governing Council members 1999-2004

Source: ECB Monthly Bulletin April 2007

The central bank balance sheet structure is shown in the following illustration labeled Figure 6.

Central Bank Balance Sheet Structure

Standardized Central Bank Balance Sheet

Assets Liabilities Refinancing to credit institutions Credit institutions' holding on Current accounts (reserves)

Marginal lending facility Deposit facility

Net foreign assets Bank notes in circulation

Government deposits

Other factors (net)

Can Be Rearranged as Follows:

Liquidity supply through monetary policy operations refinancing to credit institutions"

Plus "marginal lending facility"

Minus "deposit facility"

Equals

Autonomous factors banknotes in circulation"

Plus "government deposits"

Minus "net foreign assets"

Plus other factors (net)

Plus

Reserves credit institutions' holding on current accounts"

Source: The Monetary Policy of the ECB (2004)

Contributions to the Banking System's Liquidity

Liquidity Liquidity Net

Providing Absorbing

Contribution

Assets) (Liabilities)

Monetary policy operations of the Eurosystem

Main refinancing operations

Longer-term refinancing operations

Other open market operation

Standing facilities

Autonomous factors affecting the banking system's liquidity

Banknotes in circulation

Government deposits with the Eurosystem

Net foreign assets 331.3

Other factors (net)

Total (b) 331.3

Reserves = credit institution's holdings on current accounts with the Eurosystem

Required reserves

Excess reserves (d)

Total (a)+(b), -+(d)

Source: The Monetary Policy of the ECB (2004)

Volume of the Main and Longer-Term Refinancing Operations

Source: The Monetary Policy of the ECB (2004)

Require Reserves and Autonomous Liquidity Factors

Source: The Monetary Policy of the ECB (2004)

The European Central Bank Monthly Bulletin (2007) states that empirical evidence on the monetary policy transmission in the euro area exists and that a good understanding of "the transmission mechanism is crucial for monetary policy." (2007) There have been several econometric models of the euro area used in making an estimation of the impacts of shifts in the short-term interest rate on both output and prices. The figure below illustrates the results of the shifts in short-term interest rates. These shifts have been based upon three different models of the euro area in what is three economic structures of a differential nature or indeed three completely different econometric methodologies. Specifically the chart shows the reactions of the GDP levels and prices to transitory percentage increases of one percentage point in the interest rate of the policy, which is under the control of the central bank maintained for two years at the higher level. The GDP response features are "qualitatively consistent across all three models. An increase in short-term interest rates results in a temporary decrease in output, which peaks about two years after the initial monetary policy impulse and reverts back to the baseline level thereafter. At the same time, prices adjust gradually to a permanently lower level. Broadly similar patterns are seen in a larger class of empirical models than those reported in the table below and they are consistent with the results for other countries and with the most consensual theoretical models of the transmission mechanism. In short, they show that monetary policy is neutral in the long run. Its effect on output is temporary while its effect on prices is permanent. However, the magnitude and the timing of these responses are quite different across models, reflecting the uncertainty about the precise features of the transmission mechanism. For instance, the peak output responses in the three models shown in the table below range between -0.38% and -0.71% and, two years after the initial interest rate shock, the price response lies in a range between -0.10% and -0.30%. Altogether, these estimates confirm the existence of long and uncertain lags in the mechanism by which monetary policy affects the price level." (European Central Bank Monthly Bulletin, 2007)

Estimates of responses of real GDP and consumer prices to a one percentage point increase in the policy-controlled interest rate in the euro area

Estimates of responses of real GDP and consumer prices to a I percentage point increase in the policy-controlled interest rate in the euro area

Real GDP Consumer prices

Year 1 Year 2-Year 3-Year 4-Year 1 Year 2-Year 3-Year 4 Model 1 -0.34 -0.71 -0.71 -0.63 -0.15 -0.30 -0.38 -0.49 Model 2 -0.22 -0.38 -0.31 -0.14 -0.09 -0.21 -0.31 -0.40 Model 3 -0.34 -0.47 -0.37 -0.28 -0.06 -0.10 -0.19 -0.31 Source: "Recent findings on monetary policy transmission," ECB's Monthly Bulletin, October 2002.

Notes: Numbers are expressed as a percentage change compared with the initial levels of GDP and the index of prices.

Model 1 is the ECB's Area-Wide Model (AWM).

Model 2 refers to an aggregate of the macroeconomic models of the national central banks of the euro area.

Model 3 is the multi-country model of the United Kingdom's National Institute of Economic and Social Research.

The simulations reported assume that the interest rate increase triggers an increase in the long-term interest rate and an exchange rate appreciation.

Source: ECB (2007)

XI. OECD'S RECOMMENDATIONS for the ECB (JANUARY, 2007)

In a January 2007 article published online the EVRO Intelligence website entitled: "The OECD's Recommendations for the European Central Bank" stated is that: "In its survey on the euro area of January 5, the OECD devotes significant space to a discussion of monetary policy, especially the role of money in monetary policy. The OECD argues that recent empirical evidence weakened two of the rationales for the use of monetary indicators by central banks: money demand functions were less stable recently than during the 1990s and the leading indicator qualities of money have diminished. The OECD suggests that the ECB may be therefore placing too high an emphasis on money in its two pillar-strategy. Furthermore, the strategy poses a communication challenge, as it is unclear to outside observers how the ECB uses the monetary pillar, and how much weight it attaches to it." (EVRO Intelligence, 2007) Four recommendations are made by the OECD which are of a design for assistant the ECB in more effective management of the monetary pillar which are those as follows: (1) "The ECB should publish additional quantified medium-term inflation forecasts, using money-based models. The ECB already publishes forecasts on the basis of the cashless New Keynesian models; (2) the ECB should improve the statistical reporting of monetary trends. At present, it publishes M3 adjusted for portfolio shifts - which recent research suggests may have better leading indicator qualities than M3 proper. The OECD quotes Otmar Issing who said the ECB had development a framework for extracting the signal in monetary developments relevant for policy. The ECB should therefore publish these low-frequency components of M3; (3) the ECB should extend the horizon of its forecasts, as it already uses forward market data; and (4) it should try to quantify the risk-distribution around its forecasts, perhaps by using a fan chart or other such tools."(EVRO Intelligence, 2007) it is believed that the ECB will fail to heed any of the stated suggestions. Because the model that the ECB is using in the euro area economy is not a monetary one the ECB would not "be in a position to deliver a monetary-based forecast of future inflation." (EVRO Intelligence, 2007)