MacroScope

Forward guidance; will it work?

By Mike Peacock
July 5, 2013

After the European Central Bank broke with tradition and gave forward guidance that interest rates will not rise for an “extended period” and could even fall, some of its members – including French policymakers Benoit Coeure and Christian Noyer, and Bundesbank chief Jens Weidmann – head to an annual gathering in the south of France.

Mark Carney’s Bank of England adopted the same tactic, showing just how alarmed the big central banks are at the potential turmoil unleashed by the Federal Reserve’s money-printing exit plan.
The big question is whether forward guidance can possibly allow them to escape the backwash from the Fed’s “tapering” when it comes or, whether in the euro zone’s case, sovereign borrowing costs will rise further, potentially pushing a number of countries back into danger territory.

An early test will come from today’s key U.S. jobs report. If it comes in strong, European bond yields are likely to rise across the curve.

This was a big move for a central bank which had hitherto spent 14 years insisting it would never “pre-commit” on interest rate policy. But it may not be decisive and further options are limited.
Draghi signalled a further cut in official rates was possible but we know that the transmission of that to the countries that need it most is faulty at best. He also threw the door wide open to push the rate on bank money deposited at the ECB into negative territory. But it’s already at zero and has not encouraged banks to lend much more into the real economy instead.

Most importantly, the OMT bond-buying programme – which has done so much to calm the euro crisis over the last year – is still unused and dormant. Its rules state that a country is only eligible if it first seeks help from the euro rescue fund (being in an existing bailout programme would count) but must also be borrowing regularly on the bond market. That rules out Greece, Portugal, Italy and Spain for now. Ireland might soon qualify but may not need the help. Ironically, the ECB’s first bond purchase scheme, the SMP, which was much more limited in scope, could have been deployed much more easily in this situation.

That leaves a repeat of last year’s offer of cheap long-term liquidity to the banks – the LTRO – but there has been little noise from within the ECB about that so far.

Finland’s ECB representative Erkki Liikanen is already out this morning saying that the length of the “extended period” at which euro zone rates will be kept at record lows is dependent on how the economy recovers. Which is obvious really, but does beg the question what the ECB will do if recovery takes hold rapidly in the second half of the year (unlikely I know).

There’s also the fact that any economic growth will be fragmented, enjoyed in some parts of the currency bloc, entirely absent in others. But then the euro zone has lived with the problems of a one-size-fits-all interest rate for its entire history to date.

Better news from Portugal, perhaps, where Prime Minister Pedro Passos Coelho said last night he had alighted upon a strategy to maintain government stability, after his finance and foreign ministers resigned in successive days and the latter threatened to pull his party out of the coalition, thereby robbing it of its parliamentary majority.

The premier was coy about the details but it sounds like the CDS-PP party will support his larger party on key policies that will keep the bailout programme just about on track.

This story is far from over. Talks are ongoing and the president will have to approve the deal after talking to all sides starting on Monday. At the root of this crisis is fatigue, even despair, about seemingly endless austerity in a country which remains deep in recession.

Its EU/IMF lenders are due back for a review in less than two weeks. Whether that will be put back remains to be seen. Passos Coelho has already said he may seek a further easing of debt-cutting goals for next year if the economic outlook worsens and further out, a second bailout of some description is increasingly likely – not the good news story the euro zone was hoping for.

The clock is ticking for Greece to come up with a detailed programme of public sector reforms to convince the EU and IMF to pay out an 8.1 billion euros  loan tranche from its second bailout.

That will go to euro zone finance ministers to peruse on Monday, Without the money, hefty bond repayments due in August being to look a bit dicey though there are suggestions that the money could be handed out in dribs and drabs to focus minds. Nobody wants a default, not least Germany ahead of its September elections.

Finance minister Stournaras insists a deal will be reached by Monday but officials in Athens have already said they won’t meet targets on loosening up public sector hiring and firing while attempting to address all other concerns.

Prime Minister Antonis Samaras has ruled out a fresh round of cuts, his government is seeking to lower its privatisation revenue target after failing to sell its natural gas operation and there is a 1 billion euros black hole in the state-run health insurer. So its lenders may demand measures to fill that.

Talks in Athens – described as “tough” – will continue through the weekend, although euro zone officials said earlier in the week they wanted to see something by the close of play today.

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