Thursday, January 22, 2015

Draghi bazooka hammers the Euro | Forward guidance – what forward guidance?

The ECB certainly did the business in its statement of monetary policy yesterday. The leak at the start of the New York session the previous day, that Quantitative Easing in the amount of €50 billion per month for a year was being considered, has been surpassed in practice. We are back to the old-fashioned way of giving forward guidance (also see below) which is to have word in the ear of a reporter or reporters and let them get on with it.

That this is a substantial package is without doubt. The amount of money to be effectively created per month is now €60 billion, with the door open for further purchases if needed. The ECB has even gotten around the German requirement, that the risk attached should not be mutualised, by stating that while sovereign bonds will be the responsibility of the individual Euro area states, purchases of agency bonds, or bonds issued to cover national expenditure but which do not rank as full government bonds, will have their risks shared collectively.

As far as the Euro had fallen before the announcement, it went even further afterwards. There was, as anticipated, a high level of short-term volatility, much of it within the ten-minute bars on the exchange rate chart above. The Euro dragged Cable, (the GBPUSD pair), down in sympathy.

Forward guidance – what forward guidance?

The Bank of Canada had become the latest central bank to demonstrate that the concept of forward guidance, the big idea that Mark Carney, the Governor of the Bank of England, made popular and which was taken up, for a period, by other central bank leaders, cannot work.

The idea was a good one. Let the markets know in advance that rate rises or other central bank controlled events are on the way, and thereby create a situation where extreme currency fluctuations are a thing of the past. (With regard to the currency, most central banks see their role, not as the agency for affecting the exchange rate, but rather as the entity which ensures that any changes that do occur, come about in an orderly fashion).

Prior to the Bank of Canada announcement, Bloomberg carried out a poll of 22 economists. Not a single one said that they expected a drop in rates. Reuters went around to 35 economists with the same question, and got the same result (There may have been some overlap).

All concerned have now learned that it is impossible to foretell the future. In the Canadian case it was the dramatic fall in the price of oil that caused the upset, but there will always be factors affecting the economy that are simply outside of the control of anyone, even the most powerful central banks.

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