The execution of monetary policy: a tale of two central banks

At the inception of economic and monetary union (EMU), an open question was whether execution of monetary policy by the Eurosystem could effectively stabilize liquidity and short-term interest rates. Potential problems could arise from the central bank’s limited knowledge of the new euro area market’s response to shocks, and from market participants’ limited understanding of the monetary authorities’ policy execution framework, which minimizes the central bank’s presence in the market and assigns a key liquidity-stabilization role to standing facilities and to depository institutions’ own reserve management. We find that the euro area money market has displayed a remarkable degree of stability since the inception of EMU: overnight euro rates have behaved very similarly to US federal funds rates, which are managed much more actively by the US Federal Reserve. Recent operational changes by both the Eurosystem and the Federal Reserve are leading to convergence in style of policy execution on the two sides of the Atlantic, and may foster even closer similarity in the next few years.