The euro’s story began on January 1, 1999, when the euro replaced the national currencies of the first 11 member states. Three years later, 20 years ago, the first euro banknotes and coins were introduced.
Today, the euro area numbers 19 EU countries, including Malta, with a population of over 340 million. For many citizens and businesses, the euro represents a convenient and easy means of payment for trade and travel, as well as a safe store of value.
The birth of the single currency and the setting up of the European Central Bank (ECB), created a framework for EU countries to strengthen their economies, reinforce the single market and safeguard price stability.
The Governing Council of the ECB defines the monetary policy for the whole euro area. The Governing Council includes the ECB’s Executive Board and each governor of the national central banks of the euro area member states, including the Governor of the Central Bank of Malta.
The primary objective of the ECB is price stability. In turn, the Governing Council has defined price stability in terms of the annual change in Harmonised Index of Consumer Prices (HICP) for the euro area as a whole. In July 2021, the ECB set its inflation target at two per cent over the medium term.
The stability of the euro depends on the public’s confidence in its value and the underlying economic and financial fundamentals of the euro area. Monetary policy plays a key role in this respect. Monetary policy concerns the decisions taken by central banks to influence the cost and availability of liquidity in an economy.
By raising or lowering interest rates, central banks can influence bank lending and deposit rates, as well as decisions on borrowing and saving. For instance, when interest rates rise, borrowing is more expensive, which discourages spending and reduces demand in the economy. This dampens inflationary pressures and safeguards price stability.
Interest rates are the principal monetary policy instrument that the ECB uses to affect monetary conditions. Today, interest rates are complemented by other tools, including forward guidance, asset purchases and long-term refinancing operations. Through forward guidance, the ECB makes clear its intentions for future monetary policy.
This affects interest rates today. Buying financial assets issued by the private and public sector raises bond prices and lowers their yields. The ECB also offers long-term loans to banks at very favourable interest rates, on condition that banks lend this money on to firms and households.
The primary objective of the ECB is price stability- John Caruana
A tale of two decades
The first decade of the euro’s existence was a period of steady economic growth and a gentle decline in unemployment. The global financial crisis in 2008 ended this period of economic stability. The euro area suffered a double-dip recession due to the sovereign debt crisis, before embarking on a gradual recovery.
In 2020, the COVID-19 pandemic brought this recovery to an end, with the sharpest fall in output in Europe since World War II. Vaccinations and a robust policy response led to a rapid rebound in 2021, but war in Ukraine has clouded the outlook again.
As regards prices, between 1999 and 2008, inflation was generally close to the ECB’s aim. The series of negative economic shocks that hit the euro area following the global financial crisis also put downward pressure on inflation, which was subdued for a long time, even turning negative occasionally. Rising energy prices, made worse by the war in Ukraine, have now pushed inflation in the euro area well above target.
Throughout this period, the ECB used its monetary policy instruments to keep inflation in line with its price stability objective. During its early years, interest rates were the primary monetary policy instrument. Following the global financial crisis, key interest rates were brought down close to zero.
The interest rate on the deposit facility turned negative in June 2014 and remained below zero thereafter. As a result, short-term interest rates, government bond yields and bank lending rates in the euro area fell considerably.
With interest rates at extremely low levels and inflation remaining well below the ECB’s aim, the ECB had to introduce other monetary policy tools. The asset purchase programmes and the long-term refinancing operations were aimed at injecting more liquidity into the financial system, and have led to a considerable increase in the size of the Eurosystem balance sheet.
In this way, the ECB has sought to ensure favourable financing conditions for firms and households, supporting economic activity in crisis times and moving inflation closer to its aim.
As other major central banks, the challenge the ECB faces now is that of formulating a monetary policy stance that would bring inflation down from very elevated levels to its two-per-cent aim, while limiting the damage to the euro area economy from the war in Ukraine.
This is by no means an easy task. The ECB may be required, once again, to adjust its monetary policy tools to successfully address the challenges that lie ahead.
John Caruana, International Relations Department, Central Bank of Malta.