What is the European Central Bank?
The European Central Bank (ECB) is the body which is in charge of maintaining financial stability in Eurozone countries. The linking together of the ECB with national central banks in EU countries is called the Eurosystem.
What is the main goal of the European Central Bank?
To maintain price stability and keep the purchasing power of the Euro stable. When we say price stability, we are referring to inflation. Higher levels of inflation mean that you can buy less with your money, as the price of goods goes up, whilst the value of the money you spend goes down. History is littered with cases of extreme inflation and Europe has seen it’s share, most notably hyperinflation during the era of the Weimar Republic in Germany, which contributed to Adolf Hitler’s rise to power.
How does it do it’s job?
The main way that the European Central Bank (ECB) fulfills its role is by setting interest rates for banks within the Euro area. It has 3 key areas over which it sets rates:
- The rate on the MRO (Main refinancing operations) which provide liquidity to the banking system.
- The rate on the deposit facility. This defines the interest that banks receive for depositing money with the central bank overnight.
- The rate on the marginal lending facility. This offers overnight credit to banks from the Eurosystem (which we referred to earlier).
Interest rates are very important to economies in Europe. If interest rates are low, then it follows (in theory) that businesses are more likely to try and get a loan from a bank, because they will pay less for it over the long term, while regular consumers are more likely to take loans too. The ECB wants banks to lend more, because bank lending increases the money supply. By lowering interest rates within these facilities, it provides less incentive for banks to deposit their money with a central bank, and more incentive to start loaning it. If there is more money being loaned and in the money supply, then it follows that there should be more growth, as consumers increase spending while businesses invest and expand more, hiring more staff, increasing employment, in a feedback loop which is good for economic growth. We will discuss how interest rates work in new article for our insights page soon.
How and why does the ECB affect financial markets like the stock market?
When the President of the ECB Mario Draghi, also known as ‘Super’ Mario (pictured above) makes his statement in front of a packed house of journalists and analysts revealing the latest decision of the central bank, the markets wait with baited breath.
His words have fundamental implications for European economies. This is not only because what the ECB decides to do with monetary policy reflects their perception of how Europe is currently doing economically, but also how they perceive it will perform in the future.
How it will perform of course depends on many factors. One of the most important of these is is political influences, as politics and economics are inextricably linked. For example, when Italy voted no to a referendum put forward by its Prime Minister Matteo Renzi, this worried investors. They became spooked because after the referendum, people thought Italy would be thrown into a phase of political uncertainty while it has serious problems with it’s banking sector, which may need help from the ECB in the form of bailouts. This affected investor confidence in the European continent as the value of the Euro fell immediately after the vote. Similarly after the UK voted to leave the EU, some foresaw the beginning of the end of the European Union after losing one of it’s key member states, causing sentiments to shift. The ECB has to take these political forces into account when making its decisions. At the time of the Italian referendum it did so several days after the vote, announcing a continuation of its policy of quantitative easing (QE) throughout Europe for the time being.
In very simple terms, it’s not only what the ECB actually does with policy that’s important, but what they say also signals their confidence (or lack thereof) in Eurozone economies. For example, if the Central Bank thinks that things are looking pretty good for the Eurozone, they might choose not to continue with QE, meaning that they think the future is brighter. This is similar to why speculation mounts to huge degrees ahead of statements from the Federal Reserve, which acts as the central bank for the USA. Fundamentally, the decisions from central banks like the European Central Bank (ECB) can give us strong indications about whether an economy is healthy or ill or where they think it will head in future. Since stock markets are heavily reliant on predictions, this goes hand-in-hand.
Why is the ECB important for the European Union?
The key is in the word: ‘Union’. When the EU first came into existence it went under a different name: The European Coal and Steel Community, which consisted of far fewer countries than it has today. It’s original purpose was to bring countries together who had fought bitterly against one another in the second world war like France and Germany. By bringing them together through trade and economic cooperation, the idea was that as they became economically interdependent, another devastating conflict could be avoided.
A map of the countries (in blue) which comprise the Eurozone in 2016. Image taken from Wikipedia
Seven years after it’s inception, it became the EEC (European Economic Community) and grew further. It grew to such an extent that overtime, it morphed into what we now know as the EU, which is not just about monetary union, but also about political union, meaning that it began to grow into a political institution, not just an economic one. However, the original purpose of trade and promoting financial prosperity is still as important as ever. The role of the ECB is crucial in trying to keep the Eurozone economies healthy, not only because the Euro area is the world’s third largest economy, but because many more members of the club are interconnected through the Euro, which came into existence in 1999.
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