The European Central Bank (ECB) is the central bank that oversees monetary policy of the eurozone.
The eurozone is a geographic and economic region that consists of all the European Union (EU) countries that use the euro as their national currency.
The eurozone consists of 19 countries in the EU: Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain.
The European Central Bank and the national central banks together constitute the Eurosystem, the central banking system of the euro area.
The ECB’s main task is to maintain price stability in the eurozone and to preserve the purchasing power of the euro.
It is also responsible for the safety and soundness of the banking system and the stability of the financial system within the EU region and each member country.
Under the Treaty of Rome, the ECB was also given the mandate to oversee the conduct of foreign exchange operations, to deal with the holdings and management of the official foreign reserves of the euro area countries, and to promote the smooth operation of payment systems.
The European Central Bank was established on June 1st, 1998, and is located in Frankfurt am Main, Germany.
The Central Banking System of the Euro Area
There are a lot of different “parts” of the central banking system of the euro area.
European Central Bank
The legal basis for the single monetary policy is the Treaty on the Functioning of the European Union and the Statute of the European System of Central Banks and of the European Central Bank.
The Statute established both the ECB and the European System of Central Banks (ESCB) as of 1 June 1998.
The ECB was established as the core of the Eurosystem and the ESCB.
The ECB and the national central banks together perform the tasks they have been entrusted with. The ECB has legal personality under public international law.
Currently, the ECB’s President is Christine Lagarde and the Vice-President is Luis de Guindos.
The main decision-making body is the Governing Council, which consists of the six members of the Executive Board plus the governors of the central banks of the 19 euro area countries (the “Eurogroup”).
European System of Central Banks
The ESCB comprises the ECB and the national central banks (NCBs) of all countries that are members of the EU (known as “Member States”) whether they have adopted the euro or not.
Eurosystem
The monetary authority of the eurozone is the Eurosystem.
The Eurosystem consists of the ECB and the NCBs of those countries that have adopted the euro.
The Eurosystem and the ESCB will co-exist as long as there are the EU Member States outside the euro area.
A monetary authority is an entity that manages a country’s, or in this case, a region’s currency and money supply, often with the objective of controlling inflation, interest rates, real GDP, or unemployment rate.
Eurogroup
The Eurogroup is the collective term for informal meetings of the finance ministers of the euro area. The group has 19 members.
It exercises political control over the currency and related aspects of the EU’s monetary union.
Euro area
The euro area consists of the EU countries that have adopted the euro.
The euro area came into being when responsibility for monetary policy was transferred from the national central banks of 11 EU Member States to the ECB in January 1999. Greece joined in 2001, Slovenia in 2007, Cyprus and Malta in 2008, Slovakia in 2009, Estonia in 2011, Latvia in 2014 and Lithuania in 2015.
The creation of the euro area and of a new supranational institution, the ECB, was a milestone in the long and complex process of European integration.
What is the difference between the EU and the eurozone?
The European Union (EU) is a politico-economic union of 27 member states that are located primarily in Europe.
The EU aims to integrate across a wide set of issues: member states have a single market, ensure free movement of people, goods, services, and capital.
The member states of the EU have agreed by treaty to shared sovereignty through the institutions of the European Union in some (but by no means all) aspects of government.
The eurozone, officially called the euro area, is a monetary union of 19 of the 27 European Union (EU) member states which have adopted the euro (€) as their common currency.
The eurozone (or euro area) is a subset of the EU. It boils down to common currency.
How does the ECB affect the euro?
The European Central Bank can affect the value of the euro through changes in interest rate expectations.
When interest rates expectations rise, currencies tend to appreciate.
When interest rates expectations fall, currencies tend to depreciate.
For example, if the ECB keeps interest rates unchanged but issues forward guidance that they may raise interest rates in the future, the value of the euro tends to appreciate.
Why does the central bank change the interest rate?
The ECB lowers interest rates when it is trying to stimulate the economy.
Because low-interest rates mean a low cost of borrowing, they help to stimulate the economy by making it cheaper for people to spend on credit – potentially leading to increased business activity and reduced unemployment.
The ECB raises interest rates when it is trying to contain inflation caused by an economy “overheating”.
If growth is too fast, inflation might become too high and unstable. This makes it difficult for households and businesses to plan for the future because prices are hard to predict with confidence. This can hinder spending and slow growth.
To prevent this scenario, the ECB will raise interest rates to try and temper the rate of growth in spending, and bring inflation back under control.
How to trade ECB interest rate decisions
The table below displays the possible scenarios that come from a change in interest rate expectations. Forex traders can use this information to forecast if the currency is likely to appreciate or depreciate and how to trade it.
| Market Expectations | Actual Action | Currency Impact |
|---|---|---|
| Rate Hike | Rate Hike | Neutral |
| Rate Hike | Rate Hold | Depreciation of currency |
| Rate Cut | Rate Cut | Neutral |
| Rate Cut | Rate Hold | Appreciation of currency |
| Rate Hold | Rate Hike | Appreciation of currency |
| Rate Hold | Rate Cut | Depreciation of currency |
Notice how if the market expectations are the same as the central bank’s action, the currency impact is neutral. This is because the market already “expected” this to happen so it’s already “priced in”.
When this happens, it’s important to pay attention to the comments during the press conference and listen for any new changes in interest rate expectations. If there is, these new comments are what will move the currency.