The European Central Bank (also known as the ECB) is the central bank for the euro area. It has the power to set monetary policy for the 19 countries of the Eurozone.
Its mandate is to create price stability for the euro area. To achieve this, the ECB targets a 2% level of inflation. This is the level that the ECB considers to be price stability that is:
“avoiding inflation that is too high or too low”
Here are the monetary policy tools that the ECB can use to achieve its price stability mandate:
- Set Interest rates – this is the conventional form of monetary policy. The ECB sets the main refinancing rate (the level that banks are charged to borrow from the central bank). The ECB also sets the deposit rate (the rate that banks earn interest when they deposit money at the central bank).
- Engage asset purchases/reductions – this is the ECB’s unconventional monetary policy. The ECB can buy or sell government bonds of euro area countries. If the ECB needs to loosen monetary policy it can buy bonds. If the ECB needs to tighten monetary policy it can sell bonds.
The monetary policy actions of the ECB will impact major Eurozone assets and markets, such as the euro (EUR), Eurozone government bonds and European equity markets.
The ECB’s Governing Council
The Governing Council is the forum that the ECB uses to decide upon the appropriate level of monetary policy. The Governing Council is made up of:
- 6 Executive Board Members – This includes the ECB President, a Vice President and four other board members (such as the ECB’s Chief Economist).
- 19 central bank governors of individual Eurozone countries.
At every monetary policy meeting, members vote on monetary policy decisions (interest rates and asset purchases).
Since Lithuania joined the euro area in 2015, a system of “one member, one vote” has been replaced with a rotation system. From the 25 members of the Governing Council, there are 21 votes. The votes are split between the 6 Executive Board members and the remaining 19 central bank governors.
This now means that there are effectively three different classes of Governing Council members:
- The 6 Executive Board members have permanent voting rights on monetary policy.
- The rotation voting is very slightly skewed in favour of the 5 largest economies. The 5 countries share 4 votes at every meeting (each would get a vote in 4 out of every 5 months).
- The remaining 14 members on rotation get to vote for 11 months out of every 14 months.
The ECB’s mandate
Unlike the Federal Reserve which has a dual mandate, quite simply, the ECB’s mandate is all about inflation:
“The ECB’s primary objective is the maintain price stability”.
This mandate was laid out in the Treaty on the Functioning of the European Union. However, in July 2021, the ECB’s Governing Council slightly adjusted its definition of price stability. The ECB now sees its mandate as being:
“price stability is best maintained by aiming for 2% inflation over the medium term”
The ECB uses the Harmonised Index of Consumer Prices (HICP) as its prefered measure of inflation.
Market Impact
The European Central Bank meetings are every six weeks. As the ECB has moved away from an era of Negative Interest Rate Policy (with rates now above zero) the ECB meetings have become far more eventful. The ECB has the power to move markets, especially in Eurozone assets.
N.B. As with all central banks, we look out for hints of what the ECB might do at the coming meetings. The speeches ECB members also have the power to move markets.
Eurozone bond yields (such as the German Bund, the French OAT and the Italian BTP) will be especially reactive to the decisions of the ECB. This has a subsequent impact on the EUR. Equity markets such as the German DAX, French CAC and the EURO STOXX indices will also react.
Trading the European Central Bank
| ECB decision | Likely Market Reaction |
| Tighter than expected monetary policy | Eurozone bond yields move higher * |
| EUR strengthens | |
| Indices such as DAX and CAC fall | |
| Looser than expected monetary policy | Eurozone bond yields move lower |
| EUR weakens | |
| Indices such as DAX and CAC rally | |
*Traders keep a watchful eye on moves in German bund yields but also core/periphery yield spreads. The spread of German bund yields versus the Italian BTP yields is seen as especially important.
