IntroductionPrimary objectiveThe primary objective of the ECBs monetary policy is to maintain price stability. This is the best contribution monetary policy can make to economic growth and job creation.What does monetary policy do?Monetary policy operates by steering short-term interest rates, thereby influencing economic developments, in order to maintain price stability for the euro area over the medium term.The ECB's monetary policy strategyThe ECB has adopted a specific strategy to ensure the successful conduct of monetary policy. The ECB has defined price stability as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%. In the pursuit of price stability, the ECB aims at maintaining inflation rates below, but close to, 2% over the medium term.The strategy also includes an analytical framework for the assessment of all relevant information and analysis needed to take monetary policy decisions. This framework is based on two pillars: economic analysis and monetary analysis.

StrategyMain elementsThe ECBs monetary policy strategy provides a comprehensive framework within which decisions on the appropriate level of short-term interest rates are taken. It is based on some general principles that aim to ensure a successful conduct of monetary policy.The ECBs monetary policy strategy comprises

a quantitative definition of price stability, and a two-pillar approach to the analysis of the risks to price stability.The external communication of the strategy reflects the diversified approach to monetary policy that the ECB has adopted for its internal decision-making.

Quantitative definition of price stabilityThe first element of the ECBs strategy is a quantitative definition of price stability. The ECBs Governing Council has defined price stability as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%.

Price stability is to be maintained over the medium term.

The Governing Council has clarified that, in the pursuit of price stability, it aims to maintain inflation rates below, but close to, 2% over the medium term.

Definition of price stability About the medium-term orientation

Two-pillar approachIn order to best serve its objective of maintaining price stability, the ECB, like any other central bank, needs to thoroughly analyse economic developments.

The ECB's approach to organising, evaluating and cross-checking the information relevant for assessing the risks to price stability is based on two analytical perspectives, referred to as the "two pillars": economic analysis and monetary analysis. They form the basis for the Governing Council's overall assessment of the risks to price stability and its monetary policy decisions.

Economic analysis Monetary analysis

The stability-oriented monetary policy strategy of the ECB

CommunicationThe strategy also provides a framework for explaining monetary policy decisions to the public in a clear and transparent manner.

In this respect, a high degree of transparency does not only help the central bank to carry out its mandate more effectively, but also to ensure accountability to the public. DecisionsMonetary policy decisions are taken by the ECB's Governing Council. The Council meets every month to analyse and assess economic and monetary developments and the risks to price stability and to decide on the appropriate level of the key interest rates, based on the ECB's strategy. See the section 'Monetary policy decisions' See the section 'Economic and monetary developments'ImplementationTo implement its monetary policy decisions, the Governing Council of the ECB has adopted a set of monetary policy instruments and procedures as laid down in the General documentation on Eurosystem monetary policy instruments and procedures.See the section 'Instruments'

Objective of monetary policyTo maintain price stability is the primary objective of the Eurosystem and of the single monetary policy for which it is responsible. This is laid down in the Treaty on the Functioning of the European Union, Article 127 (1)."Without prejudice to the objective of price stability", the Eurosystem shall also "support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union". These include inter alia "full employment" and "balanced economic growth".The Treaty establishes a clear hierarchy of objectives for the Eurosystem. It assigns overriding importance to price stability. The Treaty makes clear that ensuring price stability is the most important contribution that monetary policy can make to achieve a favourable economic environment and a high level of employment.These Treaty provisions reflect the broad consensus that the benefits of price stabilityare substantial (seebenefits of price stability). Maintaining stable prices on a sustained basis is a crucial pre-condition for increasing economic welfare and the growth potential of an economy . thenatural role of monetary policyin the economy is to maintain price stability (seescope of monetary policy). Monetary policy can affect real activity only in the shorter term (see thetransmission mechanism). But ultimately it can only influence the price level in the economy.The Treaty provisions also imply that, in the actual implementation of monetary policy decisions aimed at maintaining price stability, the Eurosystem should also take into account the broader economic goals of the Union. In particular, given that monetary policy can affect real activity in the shorter term, the ECB typically should avoid generating excessive fluctuations in output and employment if this is in line with the pursuit of its primary objective.

Benefits of price stabilityThe objective of price stability refers to the general level of prices in the economy. It implies avoiding both prolonged inflation and deflation. Price stability contributes to achieving high levels of economic activity and employment by improving the transparency of the price mechanism. Under price stability people can recognise changes in relative prices (i.e. prices between different goods), without being confused by changes in the overall price level. This allows them to make well-informed consumption and investment decisions and to allocate resources more efficiently; reducing inflation risk premia in interest rates (i.e. compensation creditors ask for the risks associated with holding nominal assets). This reduces real interest rates and increases incentives to invest; avoiding unproductive activities to hedge against the negative impact of inflation or deflation; reducing distortions of inflation or deflation, which can exacerbate the distortionary impact on economic behaviour of tax and social security systems; preventing an arbitrary redistribution of wealth and income as a result of unexpected inflation or deflation; and contributing to financial stability.While the Treaty clearly establishes the maintenance of price stability as the primary objective of the ECB, it does not give a precise definition of what is meant by price stability.Quantitative definition of price stabilityThe ECBs Governing Council has defined price stability as "a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%. Price stability is to be maintained over the medium term".The Governing Council has also clarified that, in the pursuit of price stability, it aims to maintain inflation rates below, but close to, 2% over the medium term. The definition of price stabilityQuantitative definitionWhile the Treaty clearly establishes the primary objective of the ECB, it does not give a precise definition of what is meant by price stability.

The ECBs Governing Council has announced a quantitative definition of price stability:

"Price stability is defined as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%."The Governing Council has also clarified that, in the pursuit of price stability, it aims to maintain inflation rates below, but close to, 2% over the medium term.BenefitsThe announcement makes the monetary policy more transparent; provides a clear and measurable yardstick against which the European citizens can hold the ECB accountable; provides guidance to the public for forming expectations of future price developments.Focus on the euro areaThe ECBs definition of price stability makes clear that the focus of its monetary policy is on the euro area as a whole. This reflects its euro area-wide mandate. Therefore, price stability is assessed on the basis of price developments in the euro area economy.SymmetryBy referring to an increase in the HICP of below 2% the definition makes clear that not only inflation above 2% but also deflation (i.e. price level declines) is inconsistent with price stability.Reasons for aiming at below, but close to, 2%Inflation rates of below, but close to, 2% are low enough for the economy to fully reap the benefits of price stability.

It also underlines the ECBs commitment to

provide an adequate margin to avoid the risks of deflation. Having such a safety margin against deflation is important because nominal interest rates cannot fall below zero. In a deflationary environment monetary policy may thus not be able to sufficiently stimulate aggregate demand by using its interest rate instrument. This makes it more difficult for monetary policy to fight deflation than to fight inflation. take into account the possibility of HICP inflation slightly overstating true inflation as a result of a small but positive bias in the measurement of price level changes using the HICP. provide a sufficient margin to address the implications of inflation differentials in the euro area. It avoids that individual countries in the euro area have to structurally live with too low inflation rates or even deflation.

Scope of monetary policyThe central bank is the sole issuer of banknotes and bank reserves. That means it is the monopoly supplier of the monetary base. By virtue of this monopoly, it can set the conditions at which banks borrow from the central bank. Therefore it can also influence the conditions at which banks trade with each other in the money market.In the short run, a change in money market interest rates induced by the central bank sets in motion a number of mechanisms and actions by economic agents. Ultimately the change will influence developments in economic variables such as output or prices. This process also known as the monetary policytransmission mechanism is highly complex. While its broad features are understood, there is no consensus on its detailed functioning.Long-run neutrality of moneyIt is widely agreed that in the long run after all adjustments in the economy have worked through a change in the quantity of money in the economy will be reflected in a change in the general level of prices. But it will not induce permanent changes in real variables such as real output or unemployment.This general principle, referred to as "the long-run neutrality of money", underlies all standard macroeconomic thinking. Real income or the level of employment are, in the long term, essentially determined by real factors, such as technology, population growth or the preferences of economic agents.Inflation a monetary phenomenonIn the long run a central bank can only contribute to raising the growth potential of the economy by maintaining an environment of stable prices. It cannot enhance economic growth by expanding the money supply or keeping short-term interest rates at a level inconsistent with price stability. It can only influence the general level of prices.Ultimately, inflation is a monetary phenomenon. Prolonged periods of high inflation are typically associated with high monetary growth. While other factors (such as variations in aggregate demand, technological changes or commodity price shocks) can influence price developments over shorter horizons, over time their effects can be offset by a change in monetary policy.

Transmission mechanism of monetary policyThis is the process through which monetary policy decisions affect the economy in general and the price level in particular. The transmission mechanism is characterised by long, variable and uncertain time lags. Thus it is difficult to predict the precise effect of monetary policy actions on the economy and price level.The chart below provides a schematic illustration of the main transmission channels of monetary policy decisions.

Change in official interest ratesThe central bank provides funds to the banking system and charges interest. Given its monopoly power over the issuing of money, the central bank can fully determine this interest rate.Affects banks and money-market interest ratesThe change in the official interest rates affects directly money-market interest rates and, indirectly, lending and deposit rates, which are set by banks to their customers.Affects expectationsExpectations of future official interest-rate changes affect medium and long-term interest rates. In particular, longer-term interest rates depend in part on market expectations about the future course of short-term rates.Monetary policy can also guide economic agents expectations of future inflation and thus influence price developments. A central bank with a high degree of credibility firmly anchors expectations of price stability. In this case, economic agents do not have to increase their prices for fear of higher inflation or reduce them for fear of deflation.Affects asset pricesThe impact on financing conditions in the economy and on market expectations triggered by monetary policy actions may lead to adjustments in asset prices (e.g. stock market prices) and the exchange rate. Changes in the exchange rate can affect inflation directly, insofar as imported goods are directly used in consumption, but they may also work through other channels.Affects saving and investment decisionsChanges in interest rates affect saving and investment decisions of households and firms. For example, everything else being equal, higher interest rates make it less attractive to take out loans for financing consumption or investment.In addition, consumption and investment are also affected by movements in asset prices via wealth effects and effects on the value of collateral. For example, as equity prices rise, share-owning households become wealthier and may choose to increase their consumption. Conversely, when equity prices fall, households may reduce consumption.Asset prices can also have impact on aggregate demand via the value of collateral that allows borrowers to get more loans and/or to reduce the risk premia demanded by lenders/banks.Affects the supply of creditFor example, higher interest rates increase the risk of borrowers being unable to pay back their loans. Banks may cut back on the amount of funds they lend to households and firms. This may also reduce the consumption and investment by households and firms respectively.Leads to changes in aggregate demand and pricesChanges in consumption and investment will change the level of domestic demand for goods and services relative to domestic supply. When demand exceeds supply, upward price pressure is likely to occur. In addition, changes in aggregate demand may translate into tighter or looser conditions in labour and intermediate product markets. This in turn can affect price and wage-setting in the respective market.Affects the supply of bank loansChanges in policy rates can affect banks marginal cost for obtaining external finance banks differently, depending on the level of a banks own resources, or bank capital. This channel is particularly relevant in bad times such as a financial crisis, when capital is scarcer and banks find it more difficult to raise capital.In addition to the traditional bank lending channel, which focuses on the quantity of loans supplied, a risk-taking channel may exist when banks incentive to bear risk related to the provision of loans is affected. The risk-taking channel is thought to operate mainly via two mechanisms. First, low interest rates boost asset and collateral values. This, in conjunction with the belief that the increase in asset values is sustainable, leads both borrowers and banks to accept higher risks. Second, low interest rates make riskier assets more attractive, as agents search for higher yields. In the case of banks, these two effects usually translate into a softening of credit standards, which can lead to an excessive increase in loan supply.

Monetary policy instrumentsOperational FrameworkIn order to achieve its primary objective, the Eurosystem uses a set of monetary policy instruments and procedures. This set forms the operational framework to implement the single monetary policy (seeinstruments).Monopoly supplier of monetary baseThe Eurosystem is the sole issuer of banknotes and bank reserves in the euro area. This makes it the monopoly supplier of the monetary base, which consists of currency (banknotes and coins) in circulation, the reserves held by counterparties with the Eurosystem, and recourse by credit institutions to the Eurosystems deposit facility.These items are liabilities in the Eurosystems balance sheet. Reserves can be broken down further into required and excess reserves.In the Eurosystems minimum reserve system, counterparties are obliged to hold reserves with the national central banks (NCBs). Beyond that, credit institutions usually hold only a small amount of voluntary excess reserves with the Eurosystem.By virtue of its monopoly, a central bank is able to manage the liquidity situation in the money market and influence money market interest rates.Signalling the monetary policy stanceIn addition to steering interest rates by managing liquidity, the central bank can also signal its monetary policy stance to the money market. This is usually done by changing the conditions under which the central bank is willing to enter into transactions with credit institutions.Ensuring proper functioning of the money marketIn its operations, the central bank also aims to ensure a proper functioning of the money market and to help credit institutions meet their liquidity needs in a smooth manner. This is achieved by providing both regular refinancing to credit institutions and facilities that allow them to deal with end-of-day balances and to cushion transitory liquidity fluctuations.Guiding principlesThe operational framework of the Eurosystem is based on the principles laid down in the Treaty on the Functioning of the European Union. Article 127 of that Treaty states that in pursuing its objectives, the Eurosystem "() shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources ()".In addition to the principles set out in the Treaty on the Functioning of the European Union, the operational framework follows several guiding principles.Operational efficiencyThe most important principle is operational efficiency. It can be defined as the capacity of the operational framework to enable monetary policy decisions to feed through as precisely and as fast as possible to short-term money market rates. These in turn, through the monetary policy transmission mechanism, affect the price level.Equal treatment and harmonisationAnother principle is that credit institutions must be treated equally irrespective of their size and location in the euro area. The harmonisation of rules and procedures helps to ensure equal treatment by trying to provide identical conditions to all credit institutions in the euro area in transactions with the Eurosystem.Decentralised implementationOne principle specific to the Eurosystem is the decentralised implementation of monetary policy. The ECB coordinates the operations and the national central banks (NCBs) carry out the transactions.Simplicity, transparency, continuity, safety and cost efficiencySimplicity and transparency ensure that the intentions behind monetary policy operations are correctly understood. The principle of continuity aims at avoiding major changes in instruments and procedures, so that central banks and their counterparties can draw on experience when participating in monetary policy operations. The principle of safety requires that the Eurosystems financial and operational risks are kept to a minimum. Cost efficiency means keeping low the operational costs to both the Eurosystem and its counterparties arising from the operational framework.

The Eurosystem's instrumentsThe operational framework of the Eurosystem consists of the following set of instruments: open market operations, standing facilities, minimum reserve requirements for credit institutions.

ParticipationThe monetary policy framework strives to ensure the participation of a broad range of counterparties. Only institutions subject to minimum reserves may have access to the standing facilities and participate in open market operations based on standard tenders. For outright transactions, no restrictions are placed a priori on the range of counterparties.

OpenmarketoperationsOpen market operations play an important role in steering interest rates, managing the liquidity situation in the market and signalling the monetary policy stance.

Five types of instruments are available to the Eurosystem. The most important instrument is reverse transactions, which are applicable on the basis of repurchase agreements or collateralised loans. The Eurosystem may also make use of outright transactions, issuance of debt certificates, foreign exchange swaps and collection of fixed-term deposits.

Open market operations are initiated by the ECB, which decides on the instrument and on the terms and conditions. It is possible to execute open market operations on the basis of standard tenders, quick tenders or bilateral procedures.Four types of open market operationsOpen market operations can differ in terms of aim, regularity and procedure.

Main refinancing operationsare regular liquidity-providing reverse transactions with a frequency and maturity of one week. They are executed by the NCBs on the basis of standard tenders and according to a pre-specified calendar. The main refinancing operations play a pivotal role in fulfilling the aims of the Eurosystem's open market operations and normally provide the bulk of refinancing to the financial sector. Longer-term refinancing operationsare liquidity-providing reverse transactions that are regularly conducted with a monthly frequency and a maturity of three months. Longer-term refinancing operations that are conduced at irregular intervals or with other maturities, e.g. the length of one maintenance period, six months, twelve months or thirty-six months are also possible. They are executed by the NCBs on the basis of standard tenders and according to a pre-specified calendar.These operations aim to provide counterparties with additional longer-term refinancing. As a rule, the Eurosystem does not intend to send signals to the market by means of these operations and therefore normally acts as a rate taker. On some occasions and under exceptional market circumstances the ECB has also conducted longer-term refinancing operations at a fixed rate (i.e. the Eurosystem did not act as a rate taker). Fine-tuning operationscan be executed on an ad hoc basis to manage the liquidity situation in the market and to steer interest rates. In particular, they aim to smooth the effects on interest rates caused by unexpected liquidity fluctuations. Fine-tuning operations are primarily executed as reverse transactions, but may also take the form of outright transactions, foreign exchange swaps and collection of fixed-term deposits.The instruments and procedures applied in the conduct of fine-tuning operations will be adapted to the types of transactions and the specific objectives pursued in performing the operations. Fine-tuning operations will normally be executed by the NCBs through quick tenders or bilateral procedures. The Eurosystem may select a limited number of counterparties to participate in fine-tuning operations. Structural operationscan be carried out by the Eurosystem through reverse transactions, outright transactions and issuance of debt certificates. These operations will be executed whenever the ECB wishes to adjust the structural position of the Eurosystem vis--vis the financial sector (on a regular or non-regular basis).Structural operations in the form of reverse transactions and issuance of debt instruments will be carried out by the NCBs through standard tenders. Structural operations in the form of outright transactions will be executed through bilateral procedures.

Standingfacilities

Standing facilities aim to provide and absorb overnight liquidity, signal the general monetary policy stance and bound overnight market interest rates. Two standing facilities, which are administered in a decentralised manner by the NCBs, are available to eligible counterparties on their own initiative.Marginal lending facilityCounterparties can use the marginal lending facility to obtain overnight liquidity from the NCBs against eligible assets. The interest rate on the marginal lending facility normally provides a ceiling for the overnight market interest rate.Deposit facilityCounterparties can use the deposit facility to make overnight deposits with the NCBs. The interest rate on the deposit facility normally provides a floor for the overnight market interest rate.

MinimumreservesMinimum reserves are an integral part of the operational framework for the monetary policy in the euro area.

The intent of the minimum reserve system is to pursue the aims of stabilising money market interest rates, creating (or enlarging) a structural liquidity shortage and possibly contributing to the control of monetary expansion.

The reserve requirement of each institution is determined in relation to elements of its balance sheet. In order to pursue the aim of stabilising interest rates, the Eurosystem's minimum reserve system enables institutions to make use of averaging provisions. This implies that compliance with the reserve requirement is determined on the basis of the institutions' average daily reserve holdings over a maintenance period of about one month. The reserve maintenance periods start on the settlement day of the main refinancing operation (MRO) following the Governing Council meeting at which the monthly assessment of the monetary policy stance is pre-scheduled. The required reserve holdings are remunerated at a level corresponding to the average interest rate over the maintenance period of the main refinancing operations of the Eurosystem.