MacroScope

Another backhand volley from forward guidance

Forward guidance is quickly proving to be rather backward.

While it’s a favourite game of every punter who’s not paid to make predictions to trash the track record of those who are, just about everyone who follows the European Central Bank was stunned by the timing of its decision to cut rates on Thursday.

In the days beforehand, a handful of forecasters began speculating after news of a collapse in inflation that the ECB might fire what could be their last shot on standard monetary policy using interest rates in a long time.

But the vast majority were caught off guard by the ECB’s refinancing rate cut to a record low of 0.25 percent. Even those who thought it might do so didn’t think it would until December. The quick, violent fall in the euro showed it.

The most puzzling bit is that this “surprise” move – as it is billed by nearly everyone writing about it – came only months after President Mario Draghi joined other central bank colleagues in announcing “forward guidance.”

That is a policy (which rather suspiciously was drawn up in haste after there was hardly anything in the way of interest rates left to cut) that surely has droves more people scratching their heads about what the point of it is now.

Moments difficiles

Breaking news is S&P’s downgrade of France’s credit rating to AA from AA+ putting it two notches below Germany. Finance Minister Pierre Moscovici has rushed out to declare French debt is among the safest and most liquid in the euro zone, which is true.

What is also pretty unarguable is S&P’s assessment that France’s economic reform programme is falling short and the high unemployment is weakening support for further measures. There’s also Francois Hollande’s dismal poll ratings to throw into the mix.

As a result, medium-term growth prospects are lacklustre. Euro zone GDP figures for the third quarter are out next week and France is expected to lag with growth of just 0.1 percent.

ECB rate cut takes markets by surprise – time to crack Draghi’s code


After today’s surprise ECB move it is safe to forget the code words former ECB President Jean-Claude Trichet never grew tired of using – monitoring closely, monitoring very closely, strong vigilance, rate hike. (No real code language ever emerged for rate cuts, probably because there were only a few and that was towards the end of Trichet’s term.)

His successor, Mario Draghi, has a different style, one he showcased already at his very first policy meeting, but no one believed to be the norm: He is pro-active and cuts without warning. Or at least that’s what it seems.

Today’s quarter-percentage point cut took markets and economists by surprise.

Strongly vigilant?

An alarming drop in euro zone inflation – to 0.7 percent from 1.1 percent – throws today’s European Central Bank policy meeting into very sharp relief. Not since the central bank cut interest rates in May has it been under such scrutiny.

No policy change is likely, and “sources familiar” are already talking down the threat of deflation. But the central bankers, who are mandated to target inflation at close to 2 percent, will be alarmed at the sight of price pressures evaporating. One need look no further than Japan to see the damage deflation can do, often for many years.

We reported last week that a strengthening euro has also come onto the ECB’s radar, given it could depress both growth and inflation, and that there are three camps – one wanting an interest rate cut (which we know was discussed at the last meeting), another preferring to keep the option open of another long-term liquidity flood for the banking system as was done last year, and a third wanting to do nothing.

Take-off has been delayed

Euro zone services PMIs and German industry orders data will offer the latest snapshot of the currency bloc’s economy which the European Commission now forecasts will contract by 0.4 percent this year and grow just 1.1 percent in 2014 – hardly escape velocity, in fact barely taxiing along the runway.

We know from flash readings for the euro zone and Germany that service activity expanded but at a slower rate last month. France’s reading crept back into expansionary territory for the first time since early 2012. Any revisions to those figures will be marginal leaving the focus more on Italy and Spain for which we get no preliminary release.

Italy’s service sector has been growing of late, according to the PMIs, while Spain’s has still been shrinking though at a slower pace. German industry orders posted a surprise 0.3 percent drop in August and are forecast to have grown by 0.5 percent in September.

What’s happened to euro inflation?

New European Commission macro forecasts for the euro zone and the EU have been given added significance by an alarming drop in inflation to 0.7 percent which has heaped pressure on the European Central Bank to ward off any threat of deflation.

There are myriad other questions – Will the Commission predict that Italy will miss its deficit target? What will it say to those countries in bailout programmes – particularly Greece, where the troika returns for a bailout review today, and Portugal? And what about France’s sluggish economy? PMI surveys on Monday showed it is acting as a drag on the euro zone recovery.

Against that backdrop, European Commission President Jose Manuel Barroso will speak at Frankfurt’s St. Paul’s Church, the seat of the first democratically elected parliament in Germany. He is expected to outline the political priorities of the European Union in the months to come and spell out his expectations of a new German government.

The limits of Federal Reserve forward guidance on interest rates

The ‘taper tantrum’ of May and June, as the mid-year spike in interest rates became known, appears to have humbled Federal Reserve officials into having a second look at their convictions about the power of forward guidance on interest rate policy.

Take James Bullard, president of the St. Louis Fed. He acknowledged on Friday that the Fed’s view of the separation between rates guidance and asset purchases had not been fully accepted by financial markets. “This presents challenges for the Committee,” he noted.

A decision to modestly reduce the pace of asset purchases can still leave a very accommodative policy in place to the extent forward guidance remains intact.

It’s all Greek

The EU/IMF/ECB troika is due to return to Athens to resume a review of Greece’s bailout after some sparring over budget measures.

Greece’s president and prime minister have said they will not impose any further austerity measures and hope that their ability to run a primary surplus will persuade its lenders to cut it some more slack on its bailout loans to make its debt sustainable. The EU and IMF say there will be a fiscal gap next year that must be filled by domestic measures, be they further wage and pension cuts or tax increases.

We had a round of brinkmanship last week with EU officials saying they weren’t going to turn up because Athens had not come up with plausible ways to fill a 2 billion euros hole in its 2014 budget. But on Saturday, the European Commission said the review was back on after the Greek government came up with fresh proposals.

Shock low euro zone inflation – what the economists say

The slump in euro zone inflation to 0.7 percent in October was a big shock – that figure undercut even the lowest forecast from 42 analysts polled by Reuters.

Here’s what they had to say about what it means.

Generally, they were agreed that such low inflation ratchets up the pressure on the ECB to ease policy further, although some said that October figure probably represents the trough for inflation.

Ben May, European economist, Capital Economics

“The latest euro-zone inflation and unemployment figures will increase pressure on the ECB to take further action to support the economy. Meanwhile, euro-zone unemployment rose by 60,000 in September and falls in the previous months were revised away. Given this, the unemployment rate was 12.2%, unchanged from August’s upwardly revised figure. The latest figures put a dent in hopes that the labour market may have reached a turning point.

A question of liquidity

The Federal Reserve’s decision to keep printing dollars at an unchanged rate, mirrored by the Bank of Japan sticking with its massive stimulus programme, should have surprised nobody.

But markets seem marginally discomfited, interpreting the Fed’s statement as sounding a little less alarmed about the state of the U.S. recovery than some had expected and maybe hastening Taper Day. European stocks are expected to pull back from a five-year high but this is really the financial equivalent of “How many angels can dance on the head of a pin”. The Fed’s message was little changed bar removing a reference to tighter financing conditions.

However, the top central banks have sent a signal that they think all is not yet well with the world – the Fed, BOJ, European Central Bank, Bank of England, Bank of Canada and Swiss National Bank have just announced they will make permanent their array of currency swap arrangements to provide a “prudent liquidity backstop” indefinitely.