ECB officials meeting in Frankfurt today left the main refinancing rate at 0.5 percent after reducing it by a quarter point in May. The decision was predicted by 61 of 62 economists in a Bloomberg News survey, with Morgan Stanley the only institution forecasting a cut. Draghi will hold a press conference at 2:30 p.m.
With Portugal’s 10-year bond yield yesterday climbing above 8 percent for the first time since November and the Federal Reserve signaling it may withdraw monetary stimulus, investors are now seeking assurance from the ECB president that it has no plans to end its current accommodative stance. Some economists are suggesting Draghi will go a step further and offer commitments on the path of interest rates.
“Forward guidance is something they probably will venture into,” said Nick Matthews, senior European economist at Nomura International Plc in London. “If you get closer to the lower bound and have an external environment in which rates, especially in the U.S., are moving higher, the ECB has to differentiate itself.”
Whatever It Takes
The ECB held its deposit rate at zero and its marginal lending rate at 1 percent. The Bank of England kept its bond-purchase target at 375 billion pounds ($567 billion) and maintained its key rate at 0.5 percent today, while saying in a statement that the “significant upward movement in market interest rates” weighs on the outlook for the economy.
Almost a year after Draghi halted an increase in borrowing costs by saying he’ll do “whatever it takes” to save the euro, bond investors are signaling that more is needed, in words if not in deeds. The ECB president used a form of forward guidance in March when he said for the first time that monetary policy “will remain accommodative for as long as needed.” With some economic indicators showing an improvement, his challenge now is to pledge that the central bank will keep rates low without compromising its inflation goal or boxing itself into a corner.
Additional forward guidance may help the ECB keep market interest rates in the 17-nation euro area from rising to levels that threaten to prevent the currency bloc emerging from its longest-ever recession.
“Draghi will use the press conference to reassure banks and markets that there is a consensus in favor of an accommodative policy,” said Christian Schulz, an economist at Berenberg Bank in London. “He will provide everything short of Fed-style forward guidance to signal that the ECB will keep rates very low, liquidity provision generous and the OMT commitment credible as long as necessary.”
OMT, or Outright Monetary Transactions, is the ECB’s as-yet-unused pledge to buy the bonds of crisis-hit countries in the euro area that sign up to reform conditions. Since its inception in September, it has contained sovereign borrowing costs in debt-strapped countries.
Bond yields in Portugal spiraled this week after the resignation of two of the nation’s ministers sparked concern austerity fatigue will derail fiscal reforms. Yields also climbed in Italy and Spain while declining in Germany.
The theory behind forward guidance is that it boosts weaker economies by lowering the anticipated path of interest rates while signaling the bank will tolerate higher inflation. The Fed has gone the furthest among major central banks by tying changes in its benchmark rate directly to indicators for employment and inflation, setting thresholds for the lifespan of easy money.
The ECB is looking “carefully” at the U.S. experience, Executive Board member Benoit Coeure said in an interview with The Times last week.
Still, the Fed’s example shows that forward guidance comes with risks. Financial markets slumped after Fed chairman Ben S. Bernanke said June 19 that the central bank could stop purchasing assets around the middle of next year when joblessness “would likely be in the vicinity of 7 percent.”
Central bankers including Draghi, the then Bank of England Governor Mervyn King and ECB Governing Council members said a week later an exit to current monetary policy is “distant.”
For the ECB, “guidance linked to real economic benchmarks - à la the Fed - is less likely, as highlighted by the problems of forward guidance in the U.S.,” Michala Marcussen, global head of economics at Societe Generale SA in London, said in a note this week. It also risks “possibly diluting the ECB’s primary objective of price stability,” she said.
ECB policy makers have said that the central bank’s primary goal of price stability won’t change and that inflation rates above two percent won’t be tolerated in the medium term. At the same time, Draghi has several options to choose from when extending forward guidance.
He could tell investors how long low interest rates will last, mirroring an existing commitment to supply unlimited liquidity to euro-area banks against collateral until mid-2014. If new Bank of England Governor Mark Carney’s policy at his former job at the Bank of Canada is an inspiration, the ECB might commit to keep rates low for a set period of time, unless inflation spirals above a target.
Fixing the rate charged on longer-term refinancing operations would be a more indirect commitment to keep rates unchanged. At the moment, the interest banks pay is linked to the average of the ECB’s benchmark over the life of the loan.
“The most likely form of guidance is a statement that exit is ‘very distant,’” said Richard Barwell, senior European economist at Royal Bank of Scotland Group Plc in London. “But it is possible that the Council will go the whole hog and commit to time-contingent Delphic guidance to coincide with what is already being done on the liquidity operations.”
Draghi said on June 26 in Paris that he has an “open mind” about all possible instruments. Last month, he said options include charging banks for depositing money with the ECB, easing collateral rules, reviving the market for asset-backed securities and providing investors with greater guidance on how long borrowing costs will stay low.
While euro-area unemployment rose to a record 12.2 percent in May, other indicators have signaled the economy may recover under current monetary policy. Confidence in the currency bloc jumped to the highest level in more than a year in June, a gauge of manufacturing and services output improved for third month and industrial output rose for a third month in April.
“Draghi will probably address the latest increase in bond yields,” said Carsten Brzeski, senior economist at ING in Brussels. “He will not use traditional policy tools but rather central bankers’ other powerful tool: words.”
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