Glossary: The European Central Bank

The European Central Bank (ECB), along with national central banks, is part of the European System of Central Banks, that came into operation in May 1998. It provided the institutional underpinning for the introduction of the European single currency on January 1 1999.

The ECB was set up in the Maastricht treaty to determine and implement monetary policy in the new euro-zone following European economic and monetary union (Emu).

Functions

The ECB will: define and implement the monetary policy of the euro-zone; conduct foreign-exchange operations; hold and manage the foreign-exchange reserves of the eurozone states; issue banknotes; and help to promote the smooth operation of payment systems.

The policy-makers

Interest rates under the euro are set by the governing council of the ECB, composed of an executive board and the governors of the 11 national central banks

Credibility and market impact

The policy-makers at the European central bank generally inspire confidence in the financial markets. Most will stamp on inflationary pressures, and refuse to bow to political influence, if their past record is anything to go by.

The ECB's first rate cut was welcomed as prudent insurance against deflation. Its first tightening was accepted as an early move to contain price rises.

The bank has nevertheless suffered a number of public-relations mishaps of its own making. They include public disagreements between policy-makers over the significance of the money supply and currency fluctuations. More of that below.

Monetary Policy

The ECB's primary objective is to ensure price stability. This is defined as consumer-price inflation of between zero and 2%.

Promoting growth and employment is not part of the ECB's mandate. It must, however, support the general economic policies of the EU when they do not prejudice its commitment to price stability.

The ECB has adopted what it calls a twin-pillar strategy for setting monetary policy. It targets both inflation and the money supply.

In practice, the bank's inflation forecasts will be the basis of its decisions on interest rates to begin with. The creation of the euro from 11 constituent currencies has changed the nature of the money supply; it will be many months before reliable conclusions on inflation can be drawn from it, if indeed they can be drawn at all.

This why the ECB has a "reference value" for money supply, not a target. Its reference value for the broad measure of money supply M3 is annualised growth of 4.5%. Anything higher is considered an inflationary threat. The bank cited strong growth in the money supply as a key reason behind its first ever rate rise in November.

In theory, interest-rate decisions will be taken by the governing council by a majority vote, with the president having a casting vote if there is a tie. In practice, the president has sought a consensus for rate decisions and says they have yet to be put to a vote.

The ECB's decisions are totally independent of any government. It is not obliged to release minutes of its meetings or publish its economic forecasts, although it often explains the background behind rate decisions at the press conference which follows every other meeting of the governing council.

Exchange-rate Policy

The external value of the euro is not the ECB's responsibility. The heads of states of euro-zone members may agree, after consulting the ECB, to "formulate general orientations for exchange-rate policy." However, these must not prejudice the ECB's monetary-policy goal of price stability.

It took the central bankers a few months to learn the art of currency management. Public disagreements between the policy-makers over the significance of the euro's fall on the foreign exchanges only added to the pressures on the currency.

The ECB now keeps any disagreement private. The president and the vice president have been unofficially nominated as currency spokesmen.