Is the ECB’s guidance to markets proving effective?
Investors are once again drawing comparisons between Europe and Japan as the European Central Bank (ECB) appears to be struggling to normalise monetary policy.
The ECB has pushed back its expected date for the tightening of monetary policy in its forward guidance. Previously, it had suggested that interest rates would be held at present levels until the end of the summer of 2019. Following the Governing Council's policy setting meeting on 7 March, the guidance was changed to interest rates remaining "…at their present levels at least through the end of 2019…" – potentially a three- to six-month delay.
Leading indicators of activity have been very weak in recent months. New orders, especially from the rest of the world, have fallen precipitously, and inventories have started to build. Weakness in external demand may be feeding into the domestic economy. Corporate confidence has certainly taken a hit, which has made firms reluctant to take risk and invest.
As a result, the dovish change in ECB guidance was not altogether unexpected. Indeed, we pushed out the next ECB rate rise in our forecast from September to December in anticipation of such a delay. We also expected the announcement of a new round of cheap banking loans known as TLTROs. These will replace the loans that are maturing this summer, removing the risk of a funding gap for those banks still addicted to subsidised credit.
Where there was a surprise was the timing of the announcement. The ECB still expects growth in the monetary union to rebound in the second half of this year as a number of temporary headwinds abate. This led most to believe that the ECB would wait a little longer before announcing the delay, but ECB president Mario Draghi almost took pride in being "ahead of the curve".
A central bank being ahead or behind the curve is a phrase used to describe whether policymakers are leading or reacting to market expectations, as measured by the use of futures curves. Being "behind the curve" is a criticism that a central bank has been slow to react to conditions, while being "ahead of the curve" suggests superior knowledge, which warrants investors to pay close attention to communication.
When asked about the timing of the announcement and change in forward guidance during the press conference, Draghi claimed victory in being ahead of the curve. Yet, market pricing would suggest otherwise, as the chart below shows.
Based on the OIS EONIA curve (the one-day interbank interest rate within the eurozone), there was little chance of a rate rise priced in by investors a day and even a month before the meeting. A rate rise (at least 20 basis points) was just about priced by the end of 2020. What impact did the change in forward guidance have? Almost none. The chart shows a little noise around the end of 2019 and start of 2020, but the movements are worth less than five basis points and are therefore insignificant.
The ECB stresses that its forward guidance has two components. The first is the date, which attracts most of the attention of markets. The second is the state contingent element: "[rates on hold]...and in any case for as long as necessary to ensure the continued sustained convergence of inflation to levels that are below, but close to, 2% over the medium term."
The ECB argues that the market will have seen the deterioration in the data, and that it has correctly predicted that the ECB would shift, therefore justifying the effectiveness of its forward guidance. However, the market has barely changed from three months ago, when the ECB reaffirmed its intention to raise interest rates in 2019.
The reality is that the ECB thought it was ahead of the curve when it was trying to persuade the market that it would raise rates this year, but in the end, it has given up. In response to a question during the press conference, Draghi said: "… clearly, if you have market expectations which are far away from the foreseen date of the guidance, then of course credibility becomes an issue. In this sense, I think we've if anything enhanced the credibility of the forward guidance with today's decision."
The ECB is clearly behind the curve and its communication has barely moved market expectations in months. Its delay in raising interest rates and withdrawing the non-standard elements of its monetary policy has led investors to believe that the status quo is the new normal.
This has profound implications for the profitability of banks, along with serious questions over the re-distribution effects of its policy. For example, quantitative easing and negative interest rates are thought to have boosted financial assets significantly. As assets such as equities tend to be owned by more wealthy individuals, many argue that the ECB's policies have increased inequality in society. The ECB claims that the side effect of its policy is justified by the overall boost to economic growth, but as an unelected body, this is highly controversial.
Comparisons with the Japanese experience are becoming more frequent, and it is easy to understand why. The Bank of Japan failed to tighten policy convincingly over the years, and investors are questioning whether Europe is heading down the same path, and whether policy interest rates will ever return to positive territory.
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