ECB discusses need to revise forward guidance on interest rates

Some policymakers fear overshoot of inflation

The European Central Bank’s (ECB) Monetary Policy Meeting, which took place in July, saw policymakers draw attention to the need to revise the forward guidance on interest rates.

There was reported concern among those making decisions at the ECB about a potential overshoot off its 2% inflation target, or the possibility of making long-term commitments which could damage its credibility.

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Senior officials at the bank agreed on a compromise proposal that commits to an extended period of unchanged or lower interest rates. The first hike in rates will be tied to a stronger, sustained rise in inflation.

“A large majority of members indicated that they could support the revised forward guidance proposal,” the accounts showed. “At the same time, a few members upheld their reservations, as the amended formulation did not sufficiently address their concerns.”

Commenting on the ECB meeting and revised forward guidance on interest rates, Shane O’Neill, Head of Interest Rates at Validus Risk Management, said: “There was increased anticipation for today’s meeting minutes release. The ECB’s chief economist, Philip Lane, downplayed the economic threat posed by the delta variant and committed to the PEPP program continuing until at least March 2022, and the ECB’s role in QE continuing beyond that – the result, somewhat counter-intuitively, was a large move higher in yields. German yields have their largest one day move since March.”

There was one key take away for the markets, and this was the revised forward guidance on interest rates.

“ECB members, led by Lane, have reformulated the forward guidance on interest rates to include three main points: inflation should reach target well in advance of projection horizon; the governing council should be confident that inflation is present on a durable basis; and rates should not be hiked unless underlying inflation was also judged to have made satisfactory progress towards 2%,” said O’Neill.

Immediate market reaction was very subdued – EURUSD and 10y yields virtually unchanged on the release.

“This does, however, seem like positive news for risk assets – the ECB has in effect built in a buffer to allow them to keep conditions extremely accommodative even in the face of rising inflation, as long as they perceive it as transitory. Assets negatively effected by rising inflation could come under pressure due to this rewording but as that seems a long way off in Europe, as opposed to the US for example, the accommodative nature of the change should win out and provide support to EUR risk assets.”

Attention will now switch to the September ECB meeting for any further developments on the PEPP programme and its future.

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