THE ECB EXPLAINED
The European Central Bank is the central bank for the 19 countries that use the euro as their currency. The European Central Bank is supervised by a governing council that consists of six executive board members, with one serving as the president. The executive board members are appointed by the European Council.
The main goal of the European Central Bank is to keep prices stable. They use monetary policy to support the economy and job creation.
THE MAIN GOALS OF THE ECB’S ECONOMIC POLICY
The European Central Bank’s primary goal or objective is price stability. Price stability is the control of inflation, Harmonised Index of Consumer Prices (HICP) and the exchange rate of the EUR.
- Price Stability - which is price stability or inflation
- Financial stability – Through the control of price stability and sometimes other mechanisms.
Price Stability
To keep prices stable, the European Central Bank affects the short-term interest rate for the eurozone. The European Central Bank has a target interest rate (like most central banks) of below, or close to, 2%. Although they mainly focus on inflation, GDP and unemployment data also have a big impact on the decisions the policy makers make.
If inflation goes above 2%, the European Central Bank may signal a rise in the interest rate to the public to slow down the eurozone’s economic growth and bring down inflation. If unemployment numbers are increasing and the economy is weakening, the bank may have to make the decision to lower interest rates, to stimulate the economy and job creation. A period of high inflation and high unemployment will require the policy makers to weigh the pros and cons of slowing down the economy to reduce inflation or boosting the economy to produce jobs.
Financial Stability
The European Central Bank also plays a large role in keeping the eurozone’s financial system stable. In times of a crisis they can do this by adding liquidity to the system, either by buying bonds on the open market or lowering the interest rate to extremely low levels to help distressed debt holders pay back their obligations.
If the European Central Bank does not add liquidity in times of a crisis, the entire financial system could collapse.
THE EFFECT OF ECB INTEREST RATES ON THE EURO
Interest rate effect on the Euro
The European Central Bank can influence the value of the Euro through changes in interest rate expectations. Traders should understand that currencies tend to appreciate when interest rate expectations increase, not just from increases in the actual interest rate.
For example, if the European Central Bank keeps interest rates unchanged but tells the market that they expect more interest rate hikes in future, the value of the Euro tends to appreciate.
A quantitative easing program (QE) has a similar effect to interest rates on the Euro. Quantitative easing is the buying of securities on the open market by a Central Bank in order to stimulate the economy and add liquidity to the financial system. Historically it has only been done in times of a financial crisis. Increased quantitative easing reduces the value of the Euro because it increases the amount of money in supply.
Interest rate effect on the economy
The European Central Bank lowers interest rates when it is trying to boost the economy (GDP) and increases interest rates when it is trying to control inflation caused by an economy operating above potential (overheating).
Lower interest rates boost an economy in a few ways:
Businesses can borrow money and invest in projects that will earn more than the cost of borrowing. When interest rates are lower the stock market is discounted at a lower rate, leading to an increase in stock market values which causes a wealth effect. People invest their money into the economy (stocks and other assets) because they can earn more in these assets than at currently low interest rates.
How to trade ECB interest rate decisions
The table below shows the possible scenarios that come from a change in interest rate expectations. Traders can use this information to predict if the currency is likely to appreciate or depreciate and how to trade it.
| MARKET EXPECTATIONS | ACTUAL RESULTS | RESULTING FX IMPACT |
|---|---|---|
| Rate Hike | Rate Hold | Depreciation of currency |
| Rate Cut | Rate Hold | Appreciation of currency |
| Rate Hold | Rate Hike | Appreciation of currency |
| Rate Hold | Rate Cut | Depreciation of currency |
- The European Central Bank is essential to the value of the Euro.
- The Euro tends to increase or decrease depending on changes in interest rate expectations, not just on actual changes.
- Quantitative easing has a similar effect to changes in interest rates.
- Changes in expectations of quantitative easing will have an effect on the Euro.
- Higher inflation does not mean the European Central Bank will raise interest rates, it depends on the balance between economic growth and inflation.
- The ECB will increase rates if inflation is close to, at, or above target – the ECB’s main goal is to keep prices stable (inflation).