“Monetary policy transmission” refers to the process through which monetary policy settings ultimately flow through to prices. The central banks first affect interest rates. By changing their policy rates, they influence short-term market interest rates, which in turn has a knock-on effect on longer-term interest rates. In principle, central banks can also influence longer-term interest rates more directly, for example by buying and selling bonds. However, policy rates are generally the main monetary policy instrument.
On 21 July 2022, after a protracted period of particularly low interest rates, the ECB Governing Council decided, in a first step, to raise its three key interest rates by 0.5 percentage point each. This was intended to normalise monetary policy and thus combat the current high inflation rate. At its subsequent meeting on 8 September 2022, the Governing Council took an even more significant step, raising key interest rates by 0.75 percentage point. If key interest rates rise, market interest rates also tend to rise; in other words, the monetary policy stimulus is passed on. Higher market interest rates, in turn, lead to households consuming less and firms investing less than they would at lower interest rates, thus dampening economic growth. As a result of lower demand, firms subsequently adjust their prices downwards. This ultimately weakens price pressures.
The Governing Council is responsible for price stability in the euro area as a whole. It aims to achieve an inflation rate of 2% over the medium term. But even if the inflation rate for the euro area as a whole is 2%, inflation rates in individual Member States may vary. This may be due, for example, to the fact that the euro area Member States have different economic structures or are in different phases of the business cycle.
Market rates may also differ between euro area Member States. Although the key interest rates are the same for all countries, interest rates on government bonds, for example, may vary. For instance, there may be what are known as risk premia on interest rates, above all when there are doubts on the capital market regarding the soundness of individual countries’ government finances. Potential reasons underlying such doubts include high government debt, structural growth problems or uncertain political prospects in a Member State. In the euro area, it is the responsibility of each Member State to ensure its own sound public finances and sustainable economic structures, and to assure the capital markets of these. There are also common fiscal solidarity mechanisms in place to assist individual Member States experiencing financial problems. These include, for example, the European Stability Mechanism (ESM ). However, the European Treaties prohibit the Eurosystem from providing monetary financing to the Member States. This means, amongst other things, that the ECB Governing Council is not responsible for aligning interest rate levels in the Member States.
Differing financing conditions in the individual euro area Member States are therefore usually the result of normal market activity, reflecting the specific macroeconomic and fiscal policy conditions in the individual Member States. Interest rate developments in the individual Member States may also differ from one another in the course of a normalisation of monetary policy. A key interest rate hike, for instance, makes relatively risk-free bonds more attractive to investors. At the same time, investors demand greater compensation for riskier bonds in the form of higher interest rates. Accordingly, government bond yields in Member States with high levels of government debt tend to rise more strongly when key interest rates are raised than, for example, in Member States with lower levels of debt.
However, it cannot be ruled out that self-reinforcing, destabilising undesirable developments will occur in the financial markets – for example, in course of the ECB ’s monetary policy normalisation. As a result, government, corporate or household bond yields may rise excessively and move away from fundamentals. Ultimately, there is, amongst other things, the risk of this giving rise to a self-fulfilling debt crisis.
Transmission mechanism of monetary policy
Traditionally, central banks ensure price stability by adjusting their policy rates. This simplified depiction of the transmission mechanism illustrates how a policy rate change usually affects price developments.
The starting point of the monetary policy chain presented here – the interest rate channel – is the interest rate set by the central bank at which banks can borrow money from the central bank. If the central bank raises its policy rates, the general short-term interest rate normally increases as well. Banks usually pass on the increased short-term interest rate to their customers by raising their interest rates on corporate and personal loans. The longer-term interest rate level also rises. When bank loans become more expensive, demand for such loans generally declines. As a result, credit-financed demand for goods and services in the economy weakens. In such an environment, enterprises have, amongst other things, less scope to push through price increases. Consequently, aggregate inflation is dampened and the inflation rate declines. The opposite holds true if the central bank lowers its policy rates: it becomes cheaper for enterprises and households to take out bank loans, which in turn drives enterprises to borrow in order to finance their investment activity and, at the same time, boosts consumers’ demand for durable consumer goods. Aggregate demand rises. Enterprises can raise their prices both more easily and by a greater amount. The rate of inflation tends to rise.
