ECB crisis response - a view from the engine room

Abstract

Objectives of the study:

The objective of the study is to discuss the policy options of a central bank in a financial crisis from the viewpoint of monetary policy implementation. The aim is to recognize the scenarios in which a central bank ought to resort to unconventional monetary policy measures. Furthermore, the study pursues to provide a general overview and assessment of the effectiveness of the European Central Bank's (ECB) crisis response during the financial crisis, mostly from the financial markets' perspective. Moreover, the paper entails an event study on the market effects of the ECB's announcements on some of its unconventional monetary policy measures.

Results:

The literature review concludes that there are two scenarios under which a central bank should conduct unconventional monetary policy measures. Firstly, unconventional measures are warranted when an economy is heading towards a deflationary spiral or a liquidity trap. Secondly, these measures are warranted when the monetary policy transmission mechanism is impaired. As the transmission mechanism consists of several channels an impairment of any of these channels can require a central bank response.

A general overview of the key measures finds that, during the crisis, the ECB has mainly addressed problems in monetary policy transmission whereas disinflationary pressures have only started to mount recently. In order to support the monetary policy transmission, the ECB has adopted a more passive role in liquidity management by providing liquidity to the banking system in a more flexible manner than before. It has extended the maturities of its refinancing operations and relaxed some eligibility criteria in its collateral framework. The ECB has also provided liquidity in foreign currencies. In addition, it has conducted outright asset purchases and committed to Outright Monetary Transactions (OMT). The event study finds that the OMT announcement had an immediate and significant effect on stabilization of the euro area sovereign bond while the same cannot be said about the three-year longer-term liquidity providing operations. The great success of the OMT shows that a central bank backstop is needed in a financial crisis and that a credible commitment from the central bank to support the financial system can at times have even a larger impact than outright measures.