ECB: Forward Guidance

At its July’s meeting, the ECB left key policy rates unchanged. However, the Governing Council introduced a downward bias in its monetary policy stance. For the first time the Bank adopted a forward guidance regarding key policy rates, saying that they will remain at current or lower levels for a while.

Key policy rates were left unchanged at the July’s ECB meeting. However, the Governing Council introduced a downward bias in its monetary policy stance.

According to President Draghi, there was a wide discussion regarding the possibility to cut the refi rate, adding that 0.5% is not lower bound for the refi rate. However, the Council thought that conditions have worsened since last meeting, warranted further actions. The Bank decided to depart from its “never pre-commit” framework which characterized its rate decisions, and to adopt a forward guidance regarding its key policy rates as done by other central banks. Mr Draghi stressed that key policy rates will remain at present or lower rates “for an extended period of time”.

The “extended period of time” remains a vague sentence; however, Mr Draghi said that inflation expectations, economic activity data and monetary developments, including credit growth rates, will be the ingredients of this forward guidance. Given that inflation, despite some volatility due mainly to base effects on energy prices, will remain on a downward trend this year and next, that credit growth is unlikely to pick up any time soon and that the recovery will be very muted, interest rates are unlikely to be resided before the end of next year. Any movement will be down.

The tightening of financial conditions in the eurozone, caused by the general market sell-off following the announced tapering of QE3 in the US, was among the main factors forcing the ECB to act. This is a clear illustration of how different are the positions of the US and the eurozone in their business cycles. There, the Fed, supported by the strength of the recovery could signal that, should the recovery continue to gain momentum, then the economy would be in a less need of support from the monetary policy. Here, President Draghi was forced to affirm (and repeat today) that the ECB is far from exiting from its monetary policy accommodation, and that it could take further actions if needed.

A decline inflation rates would give the ECB all the room of manoeuvre it needs to embark on further actions. In addition, the Council remains extremely prudent regarding the recent improvement of confidence indicators. Although this was good news, confidence indicators just signal that the recession in the eurozone is close to anend, but they are far from signaling a solid and strengthening recovery. Credit is still falling at rapid pace in peripheral countries while it is barely expanding in core countries. Last but not least, confidence, although increasing, is still fragile, and the mood could suddenly change. Recent political turmoil in Portugal might raise market uncertainty, and negative spill-over effects might affect financial conditions and confidence in other countries, undermining their recovery processes.

Should conditions deteriorate, or remain at this depressed level, the ECB could lower further the refi rate. The ECB might also embark on new non-standard measures, such as negative interest rate on the deposit facility (DFR). Yet, given that this operation could trigger some negative effects, such as a reduction in bank profitability and/or a drastic decrease of excess liquidity, the ECB has probably fixed the bar relatively high to implement it.

There were some questions regarding the possibility that the recent increase in Portuguese yields could trigger the OMT. Although outright purchases of debt securities would drastically reduce yields in Portugal and, probably, thanks to positive spill-overs, to others debt markets within the zone, we are still far from an activation of the OMT. One sine qua non condition for the OMT is that the country, under a full macro adjustment programme, has regained full access to the market. Portugal is clearly far from this point. In addition, after the first negative reaction, market pressures eased a little bit in Portugal. Should pressures continue to decrease, as it happened in Italy despite it remained, de facto, without a government for two months, then pressures to activate the OMT will recede as well.

BY Clemente DE LUCIA