Group Project #6 European Monetary Policy

1. Group Project #6European Monetary Policy MATT AKERS TITLOLA BAKARE VIVEK GEORGE MICHAEL LEAHY EVAN SCHAFFER YINGYI ZOU

2. Outline • The Euro Zone • The European Central Bank (ECB) • Economic Conditions in the Euro Zone • ECB Policies • Comparisons with the US

3. The Euro Zone • Members of the EU that use the Euro as their currency. Includes: Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain • The European Central Bank (ECB) manages the Euro Zone’s monetary policy through the Governing Council, which is the main decision-making body of the ECB. It consists of the six members of the Executive Board, plus the governors of the national central banks of the 16 euro area countries • The Governing Council sets monetary policy for the euro area. This includes decisions relating to monetary objectives, key interest rates, the supply of reserves (or currency) in the Eurosystem, and the establishment of guidelines for the implementation of those decisions Source – European Central Bank website – April 2010, www.ecb.int/home/html/index.en.html

4. The European Central Bank (ECB) The European Central Bank differs from the Federal Reserve Bank in their respective approaches to monetary policy Source – European Central Bank website – April 2010, www.ecb.int/home/html/index.en.html Source – Federal Reserve Bank website – April 2010, http://www.federalreserve.gov/monetarypolicy/default.htm

5. Economic Conditions in the Euro Zone • For 2009, Euro Zone saw between -3.9% and -4.1% real GDP growth. • In 2010, growth is expected to become positive again, in the 0.8% to 0.9% range. This is still below historical average of 2% for the Euro Zone, but positive growth is a good sign that economic activity is returning to normal since the recession. • Inflation was between 0.3% and 0.8% in 2009. • In 2010, inflation is expected to be in the 0.8% to 1.2% range. This inflation rate is still below the generally accepted 2% rate which is typical for a healthy economy. Source – Economic Intelligence Unit – March 2010, www.roubiniglobaleconomics.com

6. ECB Policies • The ECB has kept is primary interest rate (the repurchase rate) flat at 1% since May of 2009 • The Euro interbank rates have remained far lower than the repurchase rate and much closer to the lending facility rate of .25% in 2010 • The ECB has tried to maintain these rates to ensure that economic growth is stable. However, according to the ECB charter this concern should be secondary to inflationary issues

7. ECB Policies (cont.) • The Taylor rule gives varying results on what the ECB rate should be depending on whether we are suing annual data or more recent quarterly data. • Annual Taylor prediction: -.4% • Assumptions: • Real interest rate is 2% • Inflation was .3% in 2009 with a target of .8% in 2010, despite the ECB’s long run 2% target • GDP growth was -4% in 2009 and is forecasted at .9% in 2010 • The rule under these assumptions indicates that the ECB should continue with their quantitative easing efforts • Quarterly Taylor predication: 1.8% • Assumptions: • Real interest rate is 2% • Inflation was .4% in 4Q • Growth was .1% in 4Q • Under these updated numbers it would appear that the ECB needs to raise rates to stave off inflation according to the Taylor rule • However, the Greek crisis and relative instability of the Greek Banks are causing the ECB to keep monetary policies at low levels until the Euro Zone is more stable • Based on the policy statements of the ECB it would appear that despite the emphasis on inflation economic policy is holding more weight in policy decisions currently

8. Comparisons with the US • Despite the lower rates in the US currently, the Fed Funds rate is expected to increase late in 2010, while the ECB is not expected to seriously impact rates until the beginning of 2011 • This discrepancy can be seen in the below yield curve as the treasury yield steepens considerably starting with the 1 year maturities • The discrepancy is most likely due not only to the difference in economic health of the economies, but also the stability of the economies over the medium term

9. Comparisons with the US • The discrepancy in the yield curve is most likely due to the situation of the Euro area versus the United States • Growth forecasts are forecasted to be stronger in the US due to the healthy nature of the overall economy • The Euro Area is still dealing with the Greek bailout and its impact on the Euro area and Euro in general • Despite strong growth from member countries the ECB is charged with setting stability for the region, which could lead to varying levels of inflation in member countries. • Currently, with low inflation expectations in the Euro area the ECB has been able to focus on economic policies, this bent may need to shift if inflationary pressures that led to a 1 .5% inflation increase in March continue • The US is focused solely on economic policy currently and is struggling with how to effectively raise rates both through traditional mechanisms as well as the reduction of quantitative easing , as politicians are keeping a close watch on the central bank. • While the US can trade economic growth for inflation, the Euro area does not have that luxury and that is why despite significantly lower growth the ECB has kept rates higher than its US counterpart and will continue to do so