ECB forward guidance not strong enough

Euro drifts lower after European Central Bank president Draghi said the Bank “strongly emphasizes” its “accommodative stance on monetary policy”. Last month, Draghi mentioned forward guidance without the added emphasis.

Yet, the overall reality remains the same; as last month, Draghi reiterated there was no discussion of negative deposit rates or a reduction in the refinancing rate, and gave no hints on the euro being too high as was the case in February of last year.

The more effective way for a central bank to strengthen its forward guidance (to weaken bond yields and cap its currency) is to not simply restate it, but to add reference targets such as the unemployment threshold in the US and the UK, and even going further, with adding reference to inflation.

As we have argued here, central bank forward guidance is more effective when it succeeds at keeping currencies pressured and yields capped. The fact that the euro outperformed the USD and GBP last year proves this point.

The ECB’s forward guidance has been limited to maintaining a downward bias on interest rates and keeping the door open for negative refinancing rate. But reiterating the forward guidance without credible hints at additional easing no longer does the trick. And the euro is where the ECB wants it.

The BoE offered a bit more in forward guidance than the ECB by setting an unemployment threshold of 7.0% with a preferred inflation threshold near 2.0%. the fact that unemployment has fallen faster than the slowdown in inflation is keeping GBP underpinned and UK yields above all G7.

The Fed offers the clearest of forward guidance by further delaying rate hike prospects after stating that no rate was viable increase as long as unemployment is “considerably below 6.5%” and if inflation were “to remain below our 2% objective”. An effectively stated dual guidance goes a long way in keeping bond vigilantes in check.

Last but not least, Draghi today downplayed speculation of a near-term rate cut, by associating the latest slowdown in December Eurozone inflation to temporary seasonal factors in Germany.  The ECB is neither ready to cut rates again, nor it will signal the pulling of the trigger when non-inflation macro fundamentals are stabilizing and periphery bond yields are plunging. We do not rule out the EURUSD’s short-term pullback towards $1.33 on diverging US-Eurozone growth paths, before building on further gains towards 1.45 late in Q3 as “tightening” fatigue in the US converges with pro-Euro dynamics in terms of balance sheet liquidity and current account balances.