30th Sep 2022

The European Central Bank

What does the European Central Bank do?

The main task of the European Central Bank (ECB) is to set interest rates for the 12 countries that share the euro (known as the euro zone). Interest rates in the euro zone currently stand at two percent, their lowest rate for several decades. These rates have not changed since June 2003.

But the ECB's only role provided for it in the EU treaties is to "maintain price stability". What this actually means is that the ECB must keep inflation under control. In concrete terms, the ECB aims for an inflation rate at "close to but below two percent". Inflation in the euro area is currently 2.3 percent - considered close enough to the ceiling to represent "price stability".

What does the ECB not do?

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One of the main criticisms of the ECB is that it focuses too strictly on this price stability role. Many economists and policy-makers would like to see the ECB take a role in promoting growth in the euro area - which remains sluggish compared to the US and European economies outside the euro zone (such as the UK).

Who governs the ECB?

The ECB consists of an "executive Council", made up of six members and a "governing council", which is made up of the six members of the executive council plus the Central Bank governors of the twelve countries that share the euro.

The Governing Council usually meets twice a month at its Headquarters in Frankfurt. In the first meeting of the month, the Council sets the interest rate for the 12 countries that share the euro. In its second meeting, they discuss issues related to other tasks and responsibilities of the ECB.

The current President of the ECB is a Frenchman, Jean-Claude Trichet. Other key members of the Executive Council are Thomas Padoa-Schippoa, Otmar Issing, Lucas Papademos, Gertrude Tumpel-Gugerell and José Manuel González-Páramo.

What affects interest rate decisions?

The ECB takes into account a whole host of economic data when it decides whether to raise interest rates, cut interest rates or keep them on hold.

a) Inflation: As already stated, the ECB's sole responsibility is to maintain "price stability", i.e. to keep inflation under its self-imposed two percent ceiling. If the bank feels that inflation is rising too fast, it may decide to increase interest rates to slow inflation.

b) Growth: The ECB may decide to take the economic situation of the euro zone into account when setting interest rates, although this is not its prime concern. Generally speaking, if interest rates are cut, economic growth will increase and vice-versa. So, in situations of low economic growth, the bank will be less inclined to raise interest rates. Similarly, if an economy is "overheating" - i.e. growing too fast - the bank will be less inclined to cut interest rates.

c) Money supply: This is a measure of the level of liquidity in the economy. The ECB watches this closely because it acts as a forecast of future inflation.

d) Exchange rates: The ECB watches this closely because changes in the exchange rate affect the cost of imports. If imports are more expensive, then the price of goods in the retail sector will increase, which in turn can increase inflation.

e) Oil prices: Higher oil prices potentially affects inflation and growth. Higher oil prices mean that people pay more at the pumps, which leads directly to inflation. They also reduce the disposable income of consumers which means less is spent in other areas, which reduces consumer spending and therefore growth. Economic growth can also be dampened by higher oil prices because it constrains business and manufacturing, which rely on energy.

What criticisms does it face?

The main criticism of the ECB is that it has been too slow to react to economic inputs compared to the other main Central Banks. The ECB has not changed interest rates for the last 15 months, whereas the Federal Reserve Bank in the US cut rates sharply when growth was slow and has recently reversed that trend now they consider recovery to have taken hold.

However, the ECB has an undeniably difficult job trying to set an interest rate for twelve economies with different characteristics and different speeds of growth.

Another main criticism is a so-called "lack of transparency". Unlike the Federal Reserve or the Bank of England, the ECB does not publish minutes of its meetings. It is often argued that this makes it harder for the markets to predict interest rate changes, increasing instability. The ECB counters that it is the only major Central Bank to hold a press conference immediately after the interest rate decision and that it explains its decision in detail to the markets through the press.

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