European Monetary Policy Study

1. European Monetary Policy Study 09 April 2010 Written by: Chris Bottiglieri, Michael Kalmakis, Maxwell Shizhen Yu, Lei Zhang, Javier Sanchez

2. Euro Zone Member Countries Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, Spain • Treaty on European Union • Established EuroZone in 1998 • Created the Euro currency • Created the European Central Bank • Based in Frankfurt, Germany • Part of European System of Central Banks (ESCB) which covers all 27 EU Countries • Works completely independent from any other body • Works with national central banks to set monetary policy for all EuroZone countries

3. Missions European Central Bank and Federal Reserve EUROPEAN CENTRAL BANK FEDERAL RESERVE • Maintain price stability (inflation below, but close to 2%) • Without prejudice to the objective of price stability, to support the general economic policies of the EU to achieve a high level of employment, sustainable and non-inflationary competitiveness and convergence of economic performance • Maintain long-run growth of the monetary and credit aggregates commensurate with the country’s long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates growth • Inflation targeting as a strategy option is possible • Despite its multiple objectives, the Fed has traditionally placed more emphasis on achieving price stability • Hierarchy of objectives with overriding importance to price stability • No inflation targeting strategy is possible Source: THE EUROSYSTEM, THE US FEDERAL RESERVE AND THE BANK OF JAPAN. SIMILARITIES AND DIFFERENCES

4. Political Mandates & Monetary Policy Framework Conclusion: No significant differences in the institutional structures, monetary frameworks, or political mandates. However, there exist some meaningless differences in the way monetary policy committees operate. Source: Source: the eurosystem, the us federal reserve and the bank of japan. similarities and differences

5. Inflation Outlook • Three Factors that will affect Inflation in 2010 • Energy Prices • Industrial Goods • Wages • Commodity Prices • Commodity prices including oil have begun to increase as a global economic recovery begins to take hold. As a result, energy prices will continue to rise which will add to inflationary pressures. • A Hedge Against Inflation- Employment • As shown in the economic forecast data, unemployment levels will remain high in 2010 and slowly decrease over the next five years. Supply & Demand for labor will put downward pressure on wages limiting inflationary tendencies. *information and table from EIU Country Forecast Report Graphics from www.tradingeconomics.com/economics

6. GDP Outlook • Gross Expenditure • As reported in the EIU country report, there will be a slow recovery in expenditures and access to credit will also only slowly recover. Additionally, European banks have been slow to write off bad debts from their balance sheets, and as a result, there is still systemic risk of further financial crises. • Government Versus Private Spending • The Euro area will continue to rely on government spending during 2010 and 2011. There will be a gradual uptick in consumer spending starting at the end of 2011 once unemployment falls and consumers regain access to credit. information and table from EIU Country Forecast Report Graphics from www.tradingeconomics.com/Economics

7. Recent Changes in EURO Short Term Interest Rates Source: EIU • Short term interest rates were stable at 2% through Sept. 2005. A change in the ECB’s stance on short term rates at that time lead to an increase in the short term rate for the following periods, peaking at 5% in late 2008. • In order to fight the increasingly severe financial crisis, the ECB dramatically cut the interest rate down to below 1% over the course of just a few quarters, making the de facto real interest rate below zero.

8. Short Term Interest Rates: ECB VS the Taylor Rule Source: EIU Prior to Q4 2007, the ECB seems to have set rates in line with what the Taylor Rule would have suggested. However, the actual nominal interest rate set by the ECB from Q4 2007 to Q4 2009 was higher than what is given by the Taylor rule. The graph shows two things: that the ECB did not drop interest rates as quickly as the Taylor Rule indicated it should have in late 2008/ early 2009 (perhaps to maintain stability), and that as the Taylor Rule dropped below zero, it no longer was useful to the ECB, and they began setting policy that was not in line with the rule’s suggestion.

9. Short-term Interest Rate Comparison and Forecast Observations • The interest rates of Euro Area and US followed a similar pattern over the last decade. • Rates rise in booms and fall in busts • Both rates have been kept flat since early 2009 in response to the recent downturn • US interest rate tends to turn direction ahead of Euro Area • US interest rate fluctuates in a wider range than Euro Area interest rate Conclusion • We project that US interest rate will remain around 25 bps over the next 6 months, unless the economy clearly shows a strong recovery as reflected by all major indicators, which we don’t think will be the case in the short run. • Euro Area will also keep its interest rate around 1% over the next 6 months, because of 1) its policy of maintaining price stability, 2) its tendency to lag the US in adjusting interest rate to a new trend, 3) ECB has committed to supporting Greece through its fiscal crisis, and this includes maintaining a low interest rate.

10. Appendix

11. Reference Article Digests Fed Retains Pledge to Keep Rates Low for Extended PeriodPublished: 3/16/2010 2:27:17 PM    By: TradingEconomics.com, Federal Reserve The Federal Reserve held benchmark rates near zero on Tuesday and renewed a promise to keep them exceptionally low for an extended period while pointing to increased momentum in the economy's recovery. Information received since the Federal Open Market Committee met in January suggests that economic activity has continued to strengthen and that the labor market is stabilizing. Household spending is expanding at a moderate rate but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software has risen significantly. However, investment in nonresidential structures is declining, housing starts have been flat at a depressed level, and employers remain reluctant to add to payrolls. While bank lending continues to contract, financial market conditions remain supportive of economic growth. Although the pace of economic recovery is likely to be moderate for a time, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period. ECB Keeps Rate at 1% Published: 4/8/2010 10:12:20 AM    By: TradingEconomics.com, Bloomberg The European Central Bank left interest rates at a record low as the Greek fiscal crisis complicates its withdrawal of emergency stimulus measures. The Frankfurt-based ECB kept its benchmark interest rate at 1 percent. President Jean-Claude Trichet has already announced changes to ECB collateral rules to help Greece as it struggles to finance its debts. The ECB’s 22-member Governing Council is gradually withdrawing the measures it took to tackle Europe’s worst recession since World War II, including providing banks with unlimited cash. At the same time, concern that Greece’s crisis could spread to other nations in the 16-nation euro region is undermining confidence in the euro.