ECB preview - is the ECB already seeing the limits of its new communication policy?

The ECB holds its monthly meeting today in what may be seen as the most positive eurozone economic environment for some time.

Having previously been earmarked as a meeting which could see a further rate cut (a prediction which has evaporated due to more positive economic data) this meeting is now likely to be dominated by ECB President Mario Draghi’s attempts to restate his new communication policy.

July saw the launch of this policy, focused on ‘forward guidance’ (forecasting future interest rates) and the potential publishing of minutes of ECB meetings, in an attempt to add a new tool to the ECB’s monetary policy arsenal. However, in recent weeks there have been indications that the ECB may already be seeing the limits of such an approach.

Forward guidance struggles

• As the chart above shows (via Commerzbank) indicators suggest that future overnight short term interest rates are expected to increase, while the borrowing costs for short term bunds and other core eurozone countries have also been creeping up. Expectations of an ECB interest rate increase have also been brought forward significantly, whilst the euro has also been strengthening recently.
• Much of this is off the back of recent good data from the eurozone, of course a positive, but given that the data is far from comprehensive and problems still abound for the eurozone its clear the ECB is not yet ready to change course.
• Of course, given that it is early days for this policy and that the rate moves have been small it is impossible to draw a definitive judgement just yet, but there are signs of limits to the policy.

ECB Total Balance sheet (€m)

• The ECB is also seeing its monetary policy being effectively tightened as the Long Term Refinancing Operation (LTRO) loans are repaid, with its balance sheet shrinking (chart above) to its smallest size since the start of 2012, and no signs of banks increasing lending to the real economy to compensate. Again, a positive indicator but not quite what the ECB might have wanted with the introduction of a new tool indicating loose monetary policy for some time.
• External conditions have also not been helping. The Bank of England is facing a similar issue, for similar reasons, while the US Fed has announced the prospect of slowing down its Quantitative Easing programme – the much maligned ‘tapering’. This has unsettled markets and threatens to reduce liquidity globally – so far much of the pain has been felt in emerging markets, but it could yet spill over into peripheral Europe, hitting demand for government and corporate debt and pushing up borrowing costs.

Backing away from minutes

The other part of this new communication strategy was a move towards publishing minutes of ECB Governing Council meetings, with many ECB members issuing support. However, there are indications that this may also come up against problems (as might have been expected).

The concern has always been that divergent views within the ECB (read, from the Bundesbank) would make ECB minutes more trouble than they’re worth. Over the past few weeks we have seen the Bundesbank use its monthly bulletin to warn that rates could still increase and attempt temper the commitment under ‘forward guidance’, while its President, Jens Weidmann, has also warned of the potential "pressure" on decision makers if minutes were published. Additionally, comments from Austrian Central Bank Governor Ewald Nowotny suggested that the ECB might be backing away from the plans (such interventions are rarely made without some approval from the ECB hierarchy as we saw when minutes were proposed):

“My personal view is that of the founding fathers of the ECB…They were very cautious to secure the independence of the ECB by not giving minutes on the individual votes of the members of the Governing Council.”

All these factors then, have worked to expose some of the frailties of the ECB’s guidance policy, not least that it remains much more vague and unfocused than those employed at the US Fed and the BoE. The ECB (with some good reason) is hesitant to get into specifics over the timeline and conditions for keeping rates low – this will clearly hamper the usefulness of this policy tool (and brings us back to questions about how many tools the ECB really has at its disposal).

In fact, there is already talk of using another LTRO to bolster this policy and help stop any upward movement in rates, although given the limited impact of the initial LTROs (beyond avoiding a bank funding crisis) this may not help much.

All that said, the ECB is unlikely to drop its new communication approach in the near future, leaving Draghi the unenviable task of continuously restating the ECB’s commitment to this policy – expect this to begin in earnest at today's meeting.

Doves dominate as central banks show the way ahead in Europe

While the US has its Independence Day, Europe looks to be having its Forward guidance day.

Bad puns aside, it’s actually been quite an interesting day in the world of central banking in Europe.

First we had the new Bank of England Governor Mark Carney surprising the markets somewhat suggesting that the increase in rates which had seemingly been priced in was premature. Essentially, providing forward guidance that the BoE would keep monetary policy loose.

More interesting for us though, was that the ECB took a similar despite not much being expected to come out of today’s meeting. Below are the key points from ECB President Mario Draghi’s press conference:

• “The Governing Council expects the key ECB interest rates to remain at present or lower levels for an extended period of time.” This is essentially forward guidance (forecasting what policy will be in the future). It’s not full because there is no clear date set but still it is a big change from Draghi’s previous line of “we never pre-commit” (this has also been the line of the ECB generally since its inception). He also added at the end, “all in all we said our exit [from loose monetary policy] is very distant”.

• Draghi also stressed that the decision on this form of ‘forward guidance’ was unanimous (numerous times in the Q&A). Again surprising since the Bundesbank has previously warned against the problems of loose monetary policy, so one might expect Bundesbank President Jens Weidmann to be wary of committing to it for an extended period.

• When quizzed about whether the ECB was now simply reacting to the US Fed’s talk of tightening its monetary policy (the much maligned ‘taper’ which has sparked market volatility) Draghi insisted that the ECB takes its actions independently of those of any of the central bank. Behind the rhetoric though it seems fairly clear that the Fed’s policy has had an impact on European and global markets and the ECB felt the need to compensate for that. Draghi also said it was simply a “coincidence” that the BoE took a similar policy approach on the same day.

• As for the rest of the press conference, it was much as expected (more of the same). Draghi continued to stress the need for structural reform and for the creation of a clear banking union with a working resolution mechanism to recapitalise banks in the event that ECB find capital shortfalls when it does its asset quality review (stress test) next year. Draghi also distanced the ECB once again from action to boost lending to small and medium sized enterprises.

It seems all this caught markets somewhat unawares with stock markets rallying and both the pound and the euro weakening in response.

This suggests that central bankers may have a trick or two still up their sleeve, although the response is likely to be short lived. Ultimately, this is not a sea-change in the policy of the ECB, the fundamental challenges facing Europe remain.