Against the tide: Central bank forward guidance for doves
Dovish forward guidance from the European Central Bank has been followed by a similar approach from the Bank of England.
‘Forward guidance’ is the new buzz phrase after the main European Central Bank (ECB) meetings in July. Since US Federal Reserve chairman Ben Bernanke launched his guidance about the imminent tapering of the Fed’s asset purchase programme in June, the other central banks have jumped on this new bandwagon.
The ECB’s new forward guidance was classically woolly: current policy would be held for "not six months, not 12 months, but for an extended period", said ECB president Mario Draghi. But this is the most dovish the ECB has ever sounded. Offering forward guidance is a big shift in monetary policy terms.
It is ironic that the ECB has chosen to act now after the withdrawal of liquidity from markets triggered by the realization that Fed tapering might begin sooner rather than later. But then the downside risks to the ECB’s inflation target have been obvious for several quarters. The peripheral debt crisis itself is deflationary in character, and even the upside risks the ECB still mentions are disinflationary in the longer term (tax increases and higher commodity prices, both negative for demand).
So the ECB needs to be more aggressively dovish if it is to meet its inflation mandate. Rates might well be cut further and, if tapering in the US creates a lasting squeeze on global liquidity, the ECB will have to do even more to prevent monetary conditions from tightening. A further round of long-term refinancing operations (liquidity injections) for the banks might be one route to negate a rise in the real interest rate, although it is questionable how effective this would be given the tendency of banks to repay this funding.
The euro exchange rate will be more critical to this process. Euro resilience earlier in the year was in part because the market misread the Fed and the timing for an exit from quantitative easing. This was further exaggerated by the relative shifts in central bank balance sheets, with LTRO repayments shrinking the ECB’s, while asset purchases continued to swell the Fed’s.
But with the ECB now committed to an easy-money policy for the foreseeable future and the market focused on the outlook for Fed tightening (exiting QE), the divergent economic and monetary cycles should become the driving force. This favours both a stronger dollar and equally a weaker euro. Indeed, I see more ultimate downside in the euro from current levels of 1.285 to the US dollar than I do upside in the US dollar-yen cross at 100. New Bank of England governor Mark Carney has also reacted. The governor noted specifically that the recent rise in market rates was not warranted by the developments in the domestic economy. Furthermore, he said that an analysis on forward guidance would be produced at the August Monetary Policy Committee meeting. That reinforced the notion that (under market-designated ‘über-dove’ Carney) rates will not rise any time soon.
Although explicit forward guidance is still in the can, it is no secret that this is something Carney supports. This should help pin UK short-term rates, but it adds to risks further down the curve, particularly if UK data flow remains as robust as it has been recently.
The prospect of more explicit forward guidance from central banks has big implications for markets. It will increase the importance of local monetary policy decisions (specifically in the case of the ECB) as the Fed moves to exit from its QE measures.
And it suggests a steepening of yield curves in the US and the UK as 10-year yields continue to move out, while central banks try to guide the market towards the correct timing for the end of the era of QE.