By Tomasz Wieladek, chief European economist at T. Rowe Price
This week marks the 25th anniversary of the European Central Bank (ECB), which has witnessed significant challenges over the past quarter century. The ECB has met these tests thus far, but it had to evolve, often in large steps, designing new policies and gaining a lot more responsibility along the way.
The ECB was initially modelled on the German Bundesbank. This should not be too surprising, as the Bundesbank had the best track record by far in keeping inflation low and stable and was among the few countries to keep inflation in single digits during the turbulent 1970s. As such, the ECB’s monetary policy framework and ethos, such as focusing on monetary aggregates as a second pillar in setting interest rates, was inherited from the Bundesbank. Essentially, the ECB started life as the Bundesbank’s twin sister.
This intellectual approach of aggressive inflation fighting worked well for both the ECB and the euro for the first decade but was significantly challenged by the global financial crisis (GFC) and the European sovereign debt crisis. Euro area monetary aggregates grew rapidly during those first couple of years, as the superimposing of low German level interest rates on the other euro member countries led to rapid growth in private sector credit and monetary aggregates.
In response, the ECB continued to hike interest rates, even in 2008, when the Federal Reserve was already engaged in an aggressive cutting cycle in response to the first signs of recession. Instead of using interest rates to support the European banking sector in 2007, like the Fed, the ECB chose to use liquidity injections to stabilise money markets in 2007. However, the choice to continue hiking in response to inflationary pressures and strong monetary aggregate growth meant the ECB ended up tightening monetary policy, and hence demand, right up until the eve of the GFC.
Similarly, the ECB was also the first G-7 central bank to start hiking interest rates again in 2011, in response to large rise in commodity prices during the recovery after the GFC. Unfortunately, the European sovereign debt crisis coincided with this tightening in policy, leading to a second recession in the euro area shortly after the GFC. During this time, the ECB’s toolkit to effectively and credibly intervene in stressed financial markets in crisis times was limited.
Some of these policy constraints were self-imposed, but some were due to a lack of political consensus on how many policy levers the ECB should have and how far-reaching these instruments should be. The poor performance of the intellectual framework inherited from the Bundesbank during those years led to a significant reassessment of what effective monetary policy in the euro area should do.
Draghi’s ‘whatever it takes’
What happened next can only be described as a revolution, both in terms of the intellectual framework and responsibilities for monetary policy and financial stability. ECB President Mario Draghi famously remarked the central bank will do ‘whatever it takes’ to save the euro. The ECB successfully delivered on this promise. Importantly, the policies that followed allowed the ECB to intervene directly in government bond markets during a sovereign debt crisis. For many countries, this idea the central bank would be responsible for sovereign macro-financial stability was simply revolutionary – especially in German speaking member states.
As a result of the GFC, European policy makers also realised the importance of financial stability supervision from a macroeconomic perspective. In the following years, the ECB’s financial supervisory capacity grew significantly and vigorously implemented Basel-III regulations. This made individual country regulators less subject to regulatory capture from local financial institutions and contributed to the stability of the European banking system in the current monetary tightening cycle.
Finally, the ECB’s everyday monetary policy tools continued to be limited by the presence of the zero lower bound on interest rates. The ECB therefore eventually followed the UK and the US and adopted QE as policy tool not just for crisis times, but to help support the ECB’s price stability mandate. In this last step, the ECB completed its journey away from the twin sister of the Bundesbank to a monetary policy and financial stability framework flexible and comprehensive enough to serve the euro area effectively.
Over the last quarter century, the ECB made great leaps forward in its approach to monetary policy and with respect to its responsibilities. Importantly, the ECB’s monetary and financial policy reaction function is now a lot more reflective of the often very heterogenous preferences for the path of inflation, growth and fiscal policy of the euro area member countries. The ECB will likely continue to face challenges in the future and, like other central banks, make policy mistakes from time to time. But if we have a learned anything from the last 25 years, it is that the ECB has the drive and capability to master future challenges – even if the evolution sometimes happens slower than expected.