What are the qualitative monetary policy instruments

Monetary Policy Strategy

The Maastricht Treaty provides that the main objective of the monetary policy pursued by the Governing Council is to maintain price stability. The Governing Council has established a strategy for the quantitative definition of price stability with two pillars: an economic analysis and a monetary policy analysis.

Main objective of monetary policy

The Maastricht Treaty gives the Eurosystem responsibility for maintaining price stability in the euro area. The undersigned Member States are convinced that monetary policy to protect the currency is the best way to improve economic prospects and raise living standards. In the past have been deflation and inflation proven to be harmful: they destroy the information contained in the price structure, have incalculable effects on the value of contracts and savings, create growing uncertainty and therefore hinder the efficient distribution of funds, investments and growth.

Definition of price stability

The Governing Council has established a quantitative definition of price stability in order to create a stable reference point for price expectations and to make its work easier for the public to understand. Price stability is defined as an annual increase in harmonized index of consumer prices (HICP) defined for the euro zone of less than 2%. It must be guaranteed in the medium term. The Governing Council has made it clear that it wants to keep the inflation rate below but close to 2%.

A gradual rise in the consumer price index is seen as an indication that prices are generally stable, as the index is also influenced by “measurement errors”, mainly due to changes in spending patterns and improvements in the quality of goods and services. The targeted increase in the HICP provides scope for deflation risks.

The Eurosystem cannot be held responsible for short-term fluctuations such as price increases due to an increase in commodity prices in the international market, but it can be held accountable for the general price trend. Since its policy is medium-term, it can also react gradually and cautiously to certain unexpected forms of economic fluctuations.

The two-pillar strategy

The Eurosystem has no direct control over prices, which can only be influenced through monetary policy instruments after a lengthy process. For this reason, the Eurosystem should not react to changes in the consumer price index, but rather anticipate foreseeable developments that could jeopardize future price stability. This approach is based on a detailed analysis of all available information based on the two “pillars”: economic analysis and monetary analysis.

  • 1. Purpose of economic analysis is the determination of the risks to short and medium-term price stability. It is based on the assessment of several variables such as price index, cost index (including labor costs), exchange rates, cyclical indicators, tax policy and financial market indicators (including long-term interest rates). The Governing Council also takes into account the economic forecasts published by the Eurosystem at regular intervals.
  • 2. Through the monetary analysis the short-term indicators, which are created on the basis of the economic analysis, are to be tested in the medium and long term. Monetary analysis takes into account indicators such as the expanded money supply M3, its components - from the most liquid ones like M1 (banknotes and coins, sight deposits and electronic wallets) to less liquid ones like savings deposits, time deposits and instruments that are fungible in the short term - and their counterparts like loans for Companies and individuals.

Other monetary policy objectives

The Maastricht Treaty provides that regardless of the objective of price stability, the Eurosystem must support the general economic policy of the Union with a view to objectives such as growth, jobs and economic and social cohesion. The associated limitation clearly defines the main objective of the Eurosystem. Creating a stable environment is the best way for the system to stimulate growth and jobs, as these goals require further economic policy action.

Furthermore, interventions to maintain price stability may also have positive effects on other objectives, including stabilizing the economy and the financial sector. As a result, the risks to price stability are often linked to cyclical fluctuations: when the risks, with a view to declining economic activity, decrease, the Eurosystem lowers interest rates, which in turn increases demand.

The Treaty on the Functioning of the European Union also provides that foreign exchange policy must not jeopardize price stability. There is currently no official agreement on exchange rates between the euro and currencies outside the Union. In addition, the euro exchange rate does not play an important role in the monetary policy strategy of the Eurosystem, since the euro area is an important economy in which foreign trade only accounts for 15% of the total demand for goods and services. Rather, it falls under the second “pillar” of this strategy. However, the development of exchange rates and their consequences for internal market prices are taken into account in the economic analysis.