1.1 The European Central Bank's monetary policy and its preparation in 2019
Price stability is the main objective of monetary policy in the euro area. The Governing Council of the European Central Bank has interpreted this as meaning that the year-on-year increase in consumer prices should be below, but close to, 2% over the medium term. Monetary policy can also support other economic policy objectives of the European Union as long as the objective of price stability is not jeopardised.
The Bank of Finland’s principle mission is price stability. This objective is stipulated in the Act on the Bank of Finland, which refers to the definition of price stability denoted in the Maastricht Treaty. The Bank of Finland and the Eurosystem as a whole also have other objectives, but price stability is always foremost.
The Governor of the Bank of Finland is a member of the Governing Council of the European Central Bank (ECB), which decides the monetary policy of the euro area. Experts from the Bank of Finland contribute to the preparation of monetary policy decisions and carry out other background work. They also participate in the preparation of economic analyses and monetary policy decisions by sitting on the Eurosystem's Monetary Policy Committee and Market Operations Committee.
In 2019, the ECB responded to the deteriorating economic outlook with decisive monetary policy action
In 2019, economic sentiment was weakened by the persistence of uncertainties. Most significant were the trade dispute between the United States and China and the divorce process and ensuing delay of the United Kingdom's withdrawal from the European Union. These factors were strongly reflected in euro area growth, which was very modest.
These external demand disturbances, as well as certain country and sector-specific factors, were still considered to be temporary at the end of 2018. Yet by early 2019 it had become clear that growth prospects had weakened, particularly for the year in question. Inflation also remained muted in the euro area, with inflation expectations low as well.
The Governing Council of the ECB responded to the deteriorating economic outlook by easing its monetary policy several times in 2019. The Governing Council emphasised the need for monetary policy to remain highly accommodative for a prolonged period to support core inflation (which excludes energy and food prices) and headline inflation developments over the medium term.
The Governing Council closely monitors inflation developments and the impact of its monetary policy measures on the economy. Its monetary accommodation helps ensure that financing conditions in the euro area remain favourable. The Governing Council emphasised at each of its monetary policy meetings, and in other contexts, that it stands ready to adjust all of its instruments, as appropriate, to ensure that inflation moves towards the inflation aim in a sustained manner.
At the end of 2019 the presidency of the ECB changed hands, as Mario Draghi's eight-year term ended. His successor Christine Lagarde took up her duties as President of the European Central Bank on 11 November 2019. Upon assuming office, President Lagarde announced that the ECB would begin a review of its monetary policy framework. A similar review had last been carried out in 2003.
Monetary policy remained unchanged in early 2019
At its first monetary policy meeting of the year, on 29 January, the ECB Governing Council announced that economic activity had been weaker than expected on account of softer external demand and certain country and sector-specific factors. Growth momentum had already begun to slow during the latter half of 2018.
Risks surrounding the euro area growth outlook had increased on account of persistent and significant uncertainties relating to geopolitical factors, the threat of protectionism, vulnerabilities in emerging markets and financial market volatility. The Governing Council noted, however, that favourable financing conditions, strong labour market developments and rising wage growth would continue to support euro area growth and the gradual build-up of inflationary pressures.
The Governing Council for these reasons decided not to alter its monetary policy stance. It held the key ECB interest rates unchanged, with the interest rate on the main refinancing operations and the interest rates on the marginal lending facility and the deposit facility at 0.00%, 0.25% and -0.40%, respectively.
The Governing Council announced that it expected the key ECB interest rates to remain at their present levels at least through the summer of 2019, and in any case for as long as necessary to ensure the continued sustained convergence of inflation to levels that are below, but close to, 2% over the medium term.
As for its non-standard policy measures, the Governing Council confirmed that it would continue reinvesting, in full, the principal payments from maturing securities purchased under the asset purchase programme. It added that these reinvestments would continue for an extended period of time past the date when it starts raising the key ECB interest rates, and in any case for as long as necessary to maintain favourable liquidity conditions and an ample degree of monetary accommodation.
In spring the economic outlook deteriorates, monetary policy eased slightly
Over the course of the spring, earlier signs of a slowing pace of growth in the euro area were confirmed, especially for 2019. Economic activity remained weak particularly in the manufacturing sector, reflecting softer external demand as well as some country and sector-specific factors.
There were signs that some of these idiosyncratic factors dampening growth were beginning to fade, but their effects were proving more persistent than anticipated. Core inflation remained muted as well, and the Governing Council noted that the weaker growth dynamics would slow the convergence of inflation towards the inflation aim.
The March 2019 ECB staff macroeconomic projections foresaw euro area real GDP increasing by 1.1% in 2019, 1.6% in 2020 and 1.5% in 2021. Compared with the Eurosystem staff projections published in December 2018, the forecast for growth had been revised down substantially for 2019, and slightly for 2020. Inflation as measured by the Harmonised Index of Consumer Prices (HICP) was foreseen at 1.2% in 2019, 1.5% in 2020 and 1.6% in 2021. Compared with the December 2018 projections, the forecast for HICP inflation was revised down across the entire projection horizon.
At its monetary policy meeting in March, the ECB Governing Council decided to launch a new series of quarterly targeted longer-term refinancing operations (TLTRO III) starting in September 2019 and ending in March 2021. The precise terms of the new operations were published later, in connection with the Governing Council's meeting in June. The TLTRO III operations aim to preserve favourable bank lending conditions and the smooth transmission of monetary policy.
In addition, the Governing Council stated that the Eurosystem's lending operations would continue to be conducted as fixed rate tender procedures with full allotment. This procedure will continue for as long as necessary, and at least until the end of the reserve maintenance period starting in March 2021.
The Governing Council also adjusted its forward guidance to reflect that it now expected the key ECB interest rates to remain at their present levels at least through the end of 2019, and in any case for as long as necessary to ensure the continued sustained convergence of inflation to levels below, but close to, 2% over the medium term.
At its meeting in April, the Governing Council announced that as part of its regular economic analysis it would begin to evaluate whether the potential adverse effects of negative interest rates on the economy ought to be mitigated, in order to preserve the favourable impact of negative interest rates on bank intermediation.
In summer, the Governing Council changed its forward guidance on interest rates and prepared for new monetary policy measures
In the late spring and summer, euro area growth turned out to be slightly better than anticipated in the early part of the year. Incoming economic data and survey information still pointed to somewhat weaker growth in the second and third quarters of 2019. This was primarily due to the ongoing weakness of international trade, which was still suffering from persistent global uncertainties and negatively affecting the euro area manufacturing sector in particular.
Core inflation remained muted. Cost pressures were not being passed on to prices as quickly as forecast, although labour costs continued to strengthen and broaden on account of high levels of capacity utilisation and tightening labour markets. Measures of inflation expectations suggested that expectations had lowered.
The June 2019 Eurosystem staff macroeconomic projections for the euro area forecast real GDP growth at 1.2% in 2019, 1.4% in 2020 and 1.4% in 2021. Similarly, annual HICP inflation was forecast at 1.3% in 2019, 1.4% in 2020 and 1.6% in 2021.
Based on these data and projections, the Governing Council decided to hold the key ECB interest rates unchanged at its June meeting. In its forward guidance, the Governing Council stated that it now expected the key ECB interest rates to remain at their present levels at least through the first half of 2020, and in any case for as long as necessary to ensure the continued sustained convergence of inflation to levels that are below, but close to, 2% over the medium term.
At its meeting in July, the Governing Council adjusted its forward guidance slightly, stating that it expected the key ECB interest rates to remain at their present or lower levels at least through the first half of 2020.
In addition, the Governing Council announced that it had asked the Eurosystem Committees to investigate additional measures to secure its monetary policy objective. Such measures include, for example, reinforcing forward guidance on policy rates, mitigating the adverse effects of negative interest rates by adopting a tiered system for reserve remuneration, and investigating options for the size and composition of potential new net asset purchases.
In autumn, a new monetary policy package was launched to support inflation developments
At its meeting in September, the ECB Governing Council noted that inflation had continued to fall short of its aim, euro area activity remained weak and downside risks to growth had failed to subside. Moreover, underlying price pressures remained muted and measures of inflation expectations persisted at low levels.
This assessment was also reflected in the September 2019 ECB staff macroeconomic projections for the euro area. Annual real GDP growth was forecast at 1.1% in 2019, 1.2% in 2020 and 1.4% in 2021. Similarly, annual HICP inflation was projected at 1.2% in 2019, 1.0% in 2020 and 1.5% in 2021.
In response to the subdued and deteriorating outlook for growth and inflation, the ECB Governing Council further increased its monetary accommodation.
The Governing Council lowered the interest rate on the ECB's deposit facility by 10 basis points, to -0.50%. The Governing Council also adopted a threshold-based forward guidance, stating that it now expects the key ECB interest rates to remain at their present or lower levels until the inflation outlook has robustly converged to a level sufficiently close to, but below, 2% within the projection horizon, and such convergence has been consistently reflected in underlying inflation dynamics. Compared with the Governing Council’s earlier forward guidance, interest rate rises are now tied to inflation developments instead of an anticipated timeframe.
Regarding the asset purchase programme, the Governing Council decided to restart net asset purchases at a monthly pace of EUR 20 billion as from 1 November 2019. The Governing Council announced that purchases would continue for as long as necessary to reinforce the accommodative impact of its interest rate policy, and that they would end shortly before it began raising the key ECB interest rates. Principal payments from maturing securities purchased under the asset purchase programme will continue to be reinvested in full.
The modalities of the new series of quarterly targeted longer-term refinancing operations (TLTRO III) were relaxed to sustain favourable bank lending conditions, ensure the smooth transmission of monetary policy and further support the accommodative effects of monetary policy.
The Governing Council also announced that in order to support the bank-based transmission of monetary policy, a two-tier system for reserve remuneration would be introduced, in which part of banks’ holdings of excess liquidity would be exempted from the negative deposit facility rate.
The Governing Council noted that this package of monetary policy decisions would provide a substantial monetary stimulus. These measures were implemented to ensure that financial conditions remain very favourable and continue to support euro area growth, the ongoing build-up of domestic price pressures and, thus, the sustained convergence of inflation to the medium-term inflation aim.
Monetary policy held unchanged for the rest of the year
Towards the end of 2019 the outlook for the economy remained broadly unchanged. Euro area growth continued to be muted and inflation remained low. Despite the slowdown in growth, economic data and survey information suggested that euro area growth seemed to be stabilising somewhat.
The December 2019 Eurosystem staff macroeconomic projections for the euro area foresaw annual real GDP growth of 1.2% in 2019, 1.1% in 2020 and 1.4% in both 2021 and 2022. Annual HICP inflation was projected at 1.2% in 2019, 1.1% in 2020, 1.4% in 2021 and 1.6% in 2022.
At its monetary policy meetings in October and December, the Governing Council held its policy stance unchanged. The Governing Council noted that euro area growth would continue to be supported by favourable financing conditions, further employment gains and rising wages, the mildly expansionary euro area fiscal stance and the ongoing — albeit somewhat slower — growth in global activity. Together with the ECB's monetary policy measures, these favourable developments were projected to lead to an increase in inflation over the medium term.
At the Governing Council's meeting in December, President Lagarde announced that the ECB would begin a strategy review of its monetary policy framework, as 16 years had passed since the last review. The strategy review aims to ensure that the ECB has the best possible basis for fulfilling its mandate and acting in the best interests of EU citizens. The ECB will examine its monetary policy strategy thoroughly, analytically and with an open mind. It will consider the views of different experts and reflect on the changes to the monetary-policy operating environment observed in recent years.
President Lagarde announced that the work would begin in early 2020, with the aim of completing the review by the end of the year. Over the course of 2019, the Bank of Finland actively voiced the need for a strategy review.
Economic growth needs other policy areas to complement monetary accommodation
In sum, the ECB's monetary policy remained highly accommodative in 2019. This has been to ensure that financing conditions remain favourable for all sectors of the economy. Easier borrowing conditions for firms and households facilitate consumer spending and business investment, lending support to growth in the euro area and the build-up of domestic price pressures. This, in turn, contributes to a robust convergence of inflation to the ECB's medium-term aim.
The growth of loans to firms and households remained solid throughout the year, benefiting from the pass-through effect of the ECB's monetary accommodation on bank lending rates. The ECB’s accommodative monetary policy stance contributes to maintaining very favourable bank lending conditions and will continue to support access to financing across all economic sectors.
Raising the economy's growth potential and supporting aggregate demand will also require contributions from policy areas other than monetary policy. The ECB Governing Council has consistently and publicly called for more decisive action towards implementing the structural policies outlined in the European Commission's country-specific recommendations.
Fiscal policies also play a critical role in the foundations for growth. The ECB Governing Council has emphasised repeatedly that governments with fiscal space should be ready to act in an effective and timely manner. In countries where public debt is high, governments need to pursue prudent policies and meet structural balance targets, which will create the conditions for automatic stabilisers to operate freely. All countries should intensify their efforts to achieve a more growth-friendly composition of their public finances.
The Governing Council stresses that the transparent and consistent implementation of the European Union’s fiscal and economic governance framework, both over time and across countries, remains essential for bolstering the resilience of the euro area economy. Improving the functioning of Economic and Monetary Union remains a priority.
The Governing Council welcomes the ongoing work and urges further specific and decisive steps to complete the Banking Union and the Capital Markets Union.