ECB monetary policy (since 2009)

The role of the NBS

The role of the National Bank of Slovakia as a member of the Eurosystem is to participate in a common monetary policy in the euro area that is determined by the European Central Bank (ECB). According to the Treaty establishing the European Community, the primary objective of the single monetary policy is to maintain price stability, which contributes to the favorable economic environment and creates conditions for high level of employment and sustainable economic growth in the medium term.

Monetary policy objectives

The primary objective of the ECB's monetary policy is to maintain price stability. Quantitative definition of price stability: The ECB's 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 further clarifies that “it aims to maintain inflation rates below, but close to, 2% over the medium term”.

To 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 establishing the European Community, Article 105 (1). The Eurosystem will also "support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community". These include a "high level of employment" and "sustainable and non-inflationary growth".

The Treaty establishes a clear hierarchy of objectives for the Eurosystem and assigns overriding importance to price stability. The ensuring price stability is the most important contribution that monetary policy can make to achieve a favorable economic environment and a high level of employment.

Principles of monetary policy

Monetary policy of the ECB is based on two pillars that help to achieve the primary objective of maintaining price stability. The two pillars of monetary policy are the monetary and economic analysis. In order to be able to maintain the price stability, the ECB monitors the development of the money supply in the economy that is captured by the M3 monetary aggregate (i.e. deposits and currency) and formulates the macroeconomic outlook and estimates its impact on the future path of inflation.

In terms of monetary policy, it is equally important to have the information about the current state of the economy as well as a reliable prediction of the future economic and monetary development. The National Bank of Slovakia takes part in the forecasting process of the Eurosystem. Two predictions per year are the output of the forecasting process within the ECB. Two additional predictions are prepared by the NBS each year.

The success of maintaining price stability is closely linked to expectations of economic activity. The central bank’s communication with its surroundings is very important for the proper formation of the expectations in the economy. Statements of the president of the ECB and the members of the Governing Council shape the expectations about the further development of economic and monetary situation and can have an immediate impact on the euro exchange rate and market interest rates. Expectations about the future developments also affect wage bargaining and pricing of the goods and services in the economy.

How does the monetary policy affect the economy?

The monetary policy of the central bank affects the economy through various channels (interest rate channel, the credit channel, exchange rate channel and the wealth channel) with the use of monetary policy instruments and this process is called the monetary policy transmission mechanism.

Eurosystem, in the Slovak republic represented by the National Bank of Slovakia, is the monopoly supplier of monetary base, which consists of currency in circulation and bank reserves. This allows the central bank to set the conditions under which banks can borrow the money from it. This way, the central bank also affects the conditions under which the banks make transactions between themselves and conditions (particularly interest rates), under which commercial banks lend money to the enterprises and households. Changes in the conditions of money lending change the behavior of firms and households and determine the prices and volume of production of goods and services.

Stylised illustration of the transmission mechanism from interest rates to prices

Effectiveness of monetary policy

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 is highly complex.

It 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. 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.

Governing Council decisions

All monetary policy decisions within the Eurosystem are taken by the Governing Council. NBS Governor participates in the decision-making on monetary policy. Each member of the Governing Council has one vote. After Lithuania joins common currency on 1 January 2015, voting system will be adjusted and so called rotation system will be introduced.

The most important decisions of the Governing Council include decisions on interest rates. Interest rate decisions are usually taken once a month, but the Governing Council may decide on interest rates at any time, even outside of scheduled meetings. The decision on the interest rate does not necessarily mean a change of rates; the Governing Council may decide to leave the interest rates unchanged.