What is the ECB and what are its tasks?
The European Central Bank attracts extensive media coverage every time it decides to change the base interest rate. But do you know what effects these changes have on your life or on your financial investments? And what role does the ECB play in our economic system? We explain all this to you here in the simplest way possible.
1.- What is the ECB?
The European Central Bank, ECB, is thecentral bank of the countries of the European Union, is located in Frankfurt (Germany) and ispolitically independent. The set ofECB and all the banks of the European Union countries constitute the European System of Central Banks (ESCB). As there are still countries within the European Union that have not adopted the Euro, the so-calledThe Eurosystem is made up of the ECB and the National Central Banks (NCBs) of the member states of the European Union whose currency is the Euro.. The NCBs are dedicated to executing the decisions and policies developed by the ECB within each of the countries.
The ECB is therefore the bank of central banks.. Just like you have an account at your bank, central banks have an account at the ECB, from where they can borrow money or keep their minimum reserves. ECB accounts are also often used when banks lend money to each other.
2.- Objectives and functions of the ECB
The ECB's mission is very well described on its website. There it says thatits main function is to maintain price stability in the Eurozone. Concretely this means that your goal iskeep inflation rate, the rate at which prices grow in the Eurozone,below but close to 2% in the medium term. If the inflation rate increases disproportionately, it is called hyperinflation. Hyperinflation is just as damaging as deflation, which is negative inflation, and which brings down not only Eurozone prices but purchasing power as well. That is why the 2% rate is considered by experts as a very beneficial rate. The ECB also supports the European Union in achieving its objectives, as long as they do not conflict with price stability. The objectives of the European Union are usually economic growth and full employment.
Among the main functions of the ECB is that ofdefine and execute monetary policyof the euro zone with the aforementioned main objective of guaranteeing price stability by keeping inflation around 2%.
In recent years, the ECB has been taking on other tasks, for example, it has theexclusive right to authorize the issuance of Euro banknotes. Member states can issue money, but the amount must be authorized in advance by the ECB.
Since 1999,maintains the foreign exchange reserves of member countries and directs foreign exchange operationsif the Euro evolves undesirably against other currency reserves. In addition, since the 2008 financial crisis, it has increasingly assumedtasksfrom in the areabanking supervision and regulation.
3.- Monetary policy instruments
With the help of monetary policy, the ECBcan control the money supply, that is, the amount of money in circulation. This control of the money supply is a critical task, since it has a direct impact on inflation and, consequently, on price stability.
Yes there area lot of money in circulation, the value of money decreases. In this scenario, there is arising inflation. Conversely, if there isless money in circulation,the value of money increases and inflation slows down.
In order to fulfill its functions and achieve the objective of price stability,The ECB has various instruments, as they arethe central interest rate,minimum reserves, which banks have to deposit with the ECB,open market operations and so-called permanent facilities.
3.1.- Central interest
The central interest rate is set by the ECB itself once a month andis the interest rate at which banks can borrow money from the ECB through their central banks. This central interest rate indirectly influences the banks' interest levels. If the central interest rate is low, banks can borrow money on very favorable terms and partly transfer those favorable terms to companies, which will be able to carry out investments such as building new factories, buying a fleet of vehicles or investing in marketing. In addition, banks can also grant loans on such favorable terms to private customers, which means that consumption increases, as such customers can more easily afford to buy a house or a new car. Increased consumption and business investment encourage economic growth. If in this rising economic situation inflation were to shoot up, the ECB can increase the interest rate to control the situation.
Interest rate policy is like a balance, the ECB has to find a balance between economic growth and price stability.
We are currently in a historic phase of low interest rates. Since March 2016 the central interest rate is 0%. This means that banks can borrow money from the ECB without paying interest. Experts do not believe that the central interest rate will increase in the near future, since an increase in it could cause problems for economically weaker countries such as Spain, Italy or Greece.
3.2.- Minimum reserves
The minimum reserves are the second instrument with which the ECB can guarantee price stability in the Eurozone.Eurozone banks must mandatorily maintain a certain level of funds, called minimum reserves, in accounts with the ECB. If, for example, the ECB establishes a minimum reserve rate of 2%, banks must deposit €2 with the ECB as collateral for every €100 of stored capital and can only lend €98 to their clients. If the minimum reserve rate were to increase to 5%, banks must deposit €5 with the ECB for the same amount and only €95 in credits can be granted, thus reducing the amount of money in circulation.With the increase in minimum reserves, money is taken out of the market since less amount can be lent to bank customers.
3.3.- Open market operations
In open market operations, the ECB performsauctions of money between banks that have an account at the ECB. The ECB establishes the minimum bid interest rate, below which banks do not enter the auction. The money is distributed according to the interest rates offered. The bank that offers the highest interest rate receives the funds first, and so on until the entire auction amount is exhausted. In exchange for this short-term loan, banks have to provide admitted financial assets as collateral. When the operation expires, the banks repay the loans and return the assets that had been deposited as collateral.
3.4.- Permanent facilities
permanent facilitieshave a very short term, usually one dayand they are called permanent becausecan always be used.Banks obtain liquidity by resorting to marginal credit facilities, while marginal deposit facilities allow them to deposit their excess liquidity. As in open market operations, banks here also provide financial assets as collateral. In general, the interest rate on the marginal lending facility is significantly higher than the central interest rate, and the interest rate on the deposit facility is substantially lower than the central interest rate. That is why banks only resort to these operations when there are no other alternatives.
4.- Influence of ECB decisions on our finances
We come to the part that interests you the most, that is, what influence the ECB's decisions have on your finances. If the ECB lowers the central interest rate, then banks lower the interest they pay you for keeping money in current accounts. You can see the ECB's interest rate policy directly in your passbook or savings account. Since the financial crisis of 2008, the interest on your bank accounts has been falling steadily as the ECB has been lowering the central interest rate. We are in a phase of low interest rates in which the savings deposited in the bank hardly receive interest or even have negative interest. If you want to get decent interest, you have no choice but to invest those savings.
The advantage of the phases of low interest rates is that these are also low for loans. This is good news for people who want to buy, renovate a house or refinance a home, since you pay less interest. However, low borrowing rates carry the risk of over-indebtedness or the formation of a debt bubble.
In a phase, in which the ECB's central interest rate is high, you receive more interest on the money deposited in your passbooks or savings accounts. On the other hand, these are phases of high inflation and therefore real interest is low. Suppose, for example, that you have 3.5% interest on your savings book and that the inflation rate at that time is 3% due to a high central interest rate. Therefore, your real interest rate is only 0.5%. You have 3.5% more money, but in turn that money is worth 3% less. For this reason, you will not become millionaires in phases of high interest with the money parked in passbooks or savings accounts at the bank.