How does the ECB decide on interest rates?

If you feel a bit lost in terms of how interest rate decisions are made in the European Central Bank (ECB), I'll try to sum it up below.

1) The Eurozone consists of 20 countries. Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain are the original members from 1999, Greece joined in 2001, Slovenia in 2007, Cyprus and Malta in 2008, Slovakia in 2009, Estonia in 2011, Latvia in 2014, Lithuania in 2015 and Croatia in 2023.

2) Six other countries use the euro as their currency: The microstates of Andorra, Monaco, San Marino and the Vatican which previously were using Italian lira or Frenc francs, as well as Kosovo and Montenegro. Neither of those six are in the Eurozone, however, which means they are not part of setting the monetary policy of the Eurozone.

3) The central bank for the Eurozone is the European Central Bank (ECB) which is located in Frankfurt, Germany.

4) The 20 individual central banks, e.g. the Bank of Latvia, still exist. These central banks do not make monetary policy decisions any more but via analysis and research of the economic situation in the respective countries they help provide the ECB with input for monetary policy decisions. They also have other tasks, for instance financial sector stability.

5) The main monetary policy goal – the unambiguous primary objective, as it says in the treaty – of the Eurozone is price stability, defined as an inflation rate in the Eurozone of close to 2% “in the medium term” i.e. within a time horizon of a couple of years. This is where, in the past two years, inflation has been substantially above the 2% target, which has made the ECB react with higher interest rates. Bear in mind that the target is for the Eurozone as a whole – the inflation rate in Latvia is just a small part of the overall picture given that the country is just a small part of the zone.

6) Monetary policy decisions (primarily setting interest rates at which commercial banks can borrow from or deposit into the ECB) are made by the ECB’s Governing Council.

7) The Governing Council consists of an Executive Board of six persons plus the 20 national central bank governors (Mārtiņš Kazāks, the Bank of Latvia governor, is thus part of the Governing Council together with his counterparts in the other 19 national central banks).

8) The six persons on the Executive Board must a) be nationals of a Eurozone country and b) have strong understanding of monetary or banking issues. An otherwise charismatic basketball player will thus not be accepted, nor will a Swedish economist since Sweden is not in the Eurozone. They are appointed for a non-renewable term of 8 years to ensure independent decision-making. Think of it like this: they do not have to think about pleasing anyone in order to obtain re-election. Quite unlike politicians in many countries. They can thus concentrate on obtaining inflation close to 2% even if it makes them unpopular, which is quite likely to be the case in many countries right now…

9) The six have, since the euro’s start in 1999, always been from six different countries and the three largest EU economies (Germany, France and Italy) have always been represented. Spain is often represented whereas the remaining 2-3 seats are typically for the smaller countries (right now the Netherlands and Ireland). So far, no country that joined after 2001 has had a member on the Executive Board.

10) The smaller countries actually have stronger representation than what their populations would dictate, a bit like in the European Parliament. Estonia, Latvia, Lithuania and Finland have as many members on the Governing Council as Germany and France, although their populations are much smaller.

11) A small technicality: Of the 26 persons on the Governing Council, only 24 take part in meetings at any given time, to make decision making smoother. The two persons not present are selected on a rotating basis but with a bit of discrimination against the small countries.

12) The Governing Council typically meets twice a month and makes monetary policy decisions every six weeks; decisions that are published at a press conference.

13) But there are no minutes published after Governing Council meetings so we do not know who voted for higher interest rates and who did not (if anyone).

14) Germany is typically seen as the most hawkish country in terms of inflation fighting (and therefore of setting higher interest rates to fight inflation) and in the early days of the euro it was generally believed that Germany would tend to get its way. This has not turned out so, however, demonstrated by no fewer than three Germans that have resigned prematurely from the Executive Board, noting that they found monetary policy too soft on inflation.

15) Between July 2022 and October 2023, the ECB has raised interest rates on 10 occasions. Besides the Council members, only a fly on the wall will know who voted for or against. I am pretty sure that many of these rate rises have been perfectly uncontroversial in the light of sharply increasing inflation in 2022. But all of them? I can only speculate but I have three arguments for why the Baltic members have voted for higher rates. 1) We often see a North-South divide in the Eurozone with the Southern countries being softer in terms of monetary policy. 2) Latvia, together with Estonia, Lithuania, Finland, Netherlands, Ireland and the two non-euro countries Denmark and Sweden form the so-called New Hanseatic League, a somewhat loose group with more hawkish views in terms of many EU policies, including the Eurozone. 3) Inflation hit the Baltic countries harder than any other Eurozone countries so the determination to fight inflation may have been stronger here.

But please bear in mind that this is speculation on my part – it would have been nice to be that fly on the wall at the Governing Council meetings in Frankfurt but sadly I am not...

Morten Hansen is Head of Economics Department at Stockholm School of Economics in Riga and former Vice-Chairman at the Fiscal Discipline Council of Latvia











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