Decomposing the ECB’s ‘forward guidance’: Shifts and twists

At present, circumstances dictate that ‘forward guidance’ is the ECB’s main policy instrument.We argue that Mr. Draghi has focused his guidance on the timing of the ECB’s first rate hike, while allowing market participants’ assessment of the wider macro context to drive policy rate expectations further out. Although not conclusive, both narrative and statistical evidence support this view.

This approach has served the ECB well thus far. It recognises that Mr. Draghi’s ability to influence policy rate expectations beyond the end of his presidency could lack credibility, given that market participants may be sceptical of his ability to signal the future actions of his successor. Markets (probably correctly) expect the next ECB president to be a more hawkish, northern European.

Such a strategy remains workable if Euro area activity data now stabilise at levels consistent with comfortably-above-trend area-wide growth, since this would likely permit – in line with our current baseline forecast – a first ECB rate hike before the end of Mr. Draghi’s presidency.

But whether such an approach is sufficient should a deeper and/or more sustained slowdown in economic activity occur is an open question. Using forward guidance to address that eventuality may require more active and assertive communication from the ECB, with an institutional rather than personal bent.