On Thursday 12 December, the European Central Bank (ECB) announced its fourth interest rate cut. Contrary to many predictions, it was 0.25% and not 0.50%. But governor Christine Lagarde explicitly proposed further cuts at the next board meetings, declaring in a press conference that “the direction is set”. Words which for several commentators have implied a return to “forward guidance” of the Draghi era. But is it really like that?
Forward guidance, what is it
First, Lagarde explained that the Board of Governors discussed the size of the cut and that some proposed it to be 0.50%, but in the end everyone voted for a reduction of 0.25%.
This aspect is already less marginal than we think. For the first time since last June, when monetary easing began, the hypothesis of a maxi-cut was taken into consideration in Frankfurt. After all, the inflation expectations have weakened, as have those regarding growth in the Eurozone.
Are these few words enough to talk about “forward guidance”? First, let’s explain what it is. Until 2022, for many years the ECB committed itself to maintaining a predetermined path for its monetary policy actions. For example, he pledged to raise rates only after the stop bond purchases for a suitable period. This approach served to guide the market in its medium-term direction, so that no one had any doubts about what the institution’s path was.
Breakthrough in 2022 with inflation
With the return of inflation in 2022, “forward guidance” will be replaced by a “data dependent” approach. The ECB would have assessed what to do, meeting after meeting, based on the new macro data available. A change made necessary due to the rapid evolution underway with the boom in consumer prices. Now that Lagarde has practically announced future rate cuts, for many we have returned to the Draghi era.
However, there is nothing formal. In the statement we note a change in language, for example when monetary policy is defined as “restrictive”. But immediately afterwards it is added that “with Incoming data will continue to confirm our baseline, the direction is clear and we expect to reduce interest rates further.”
Negative market reaction
This is not “forward guidance”, but rather preparation for a change in monetary approach, not in method. And it would even be serious if it were. It would mean that the market did not understand what the ECB intended to communicate. Indeed, since the meeting, sovereign yields have risen and spreads have widened. The 2-year Bund, which captures interest rate expectations, went from 1.96% to 2.06%. The spread BTp-Bund at 10 years it was less than 108 and reached 115 basis points. Strange that investors are selling bonds just as the ECB is forced to cut rates for the following period.
The truth is that the ECB is procrastinating its “data dependent” approach on the uncertainties relating to the coming months. There geopolitical situation it is more magmatic than ever and may have further repercussions on the prices of raw materials such as oil and gas. In a month there is the inauguration of Donald Trump as president of the United States and the threat of duties it already depresses the mood of European businesses. Finally, Germany and France are in a state of political precariousness, to put it mildly. All aspects that must be considered before committing to a path on rates.
Forward guidance is not there
On the other hand the euro-dollar exchange rate remains weak and below 1.05, signaling the growing monetary divergence with the Federal Reserve. We are not at “forward guidance”, simply because the ECB is at the mercy of external events. Lagarde does not have the strength and authority to impose her thoughts on the rest of the board.
It limits itself to a more notarial management of a “consensus builder”, rather than a leader like when Mario Draghi was in Frankfurt. And it is precisely because of the uncertainty about its next moves that the bond market is reacting negatively to the latest cut launched in recent days.
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