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ECB Initiates Forward Guidance, BoE to Follow Suit

ECB Initiates Forward Guidance, BoE to Follow Suit

While most Americans were eating hot dogs and celebrating the birth date of the United States, the Bank of England and the European Central Bank took unprecedented steps in launching forward guidance in their interest rate decisions.

The move sent shares higher and the pound and the euro respectively lower as the market now expects rate hikes to come later than previously expected.

Bank of England Ties Rate Hikes to Inflation

On Thursday, the Bank of England kept its main Bank Rate at 0.5 percent, as expected, and kept the quantitative easing program constant at 375 billion pounds. However, Mark Carney, the new Bank of England Governor, in his first statement, said that the Bank will give forward guidance at its next meeting.

"The latest remit letter to the MPC from the Chancellor had requested that the Committee provide an assessment, alongside its August Inflation Report, of the case for adopting some form of forward guidance, including the possible use of intermediate thresholds," the BoE's statement read. "This analysis would have an important bearing on the Committee's policy discussions in August."

Earlier this year, the Chancellor of the Exchequer George Osborne created a "remit" for the BoE in which it wants the central bank to explore the use of forward guidance as a policy tool. By acknowledging this in the statement, markets now expect the BoE to adopt some form of forward guidance in the near future which has sent markets on a ride.

British government bond yields dropped sharply as markets were obviously pricing in a rate cut sooner than the latest statement suggested. The Bank of England did note that recent data trends have been positive for the U.K. economy however they also said that the data was in line with the BoE's outlook for the economy. "The significant upward movement in market interest rates would, however, weigh on that outlook; in the Committee's view, the implied rise in the expected future path of Bank Rate was not warranted by the recent developments in the domestic economy."

ECB Adopts Forward Guidance

As markets were recovering from the after-math that was the expected guidance from the Bank of England, only one and half hours later European Central Bank President Mario Draghi shocked markets further by formally adopting forward guidance. "Looking ahead, our monetary policy stance will remain accommodative for as long as necessary," Draghi said in his speech following the rate decision.

"The Governing Council expects the key ECB interest rates to remain at present or lower levels for an extended period of time. This expectation is based on the overall subdued outlook for inflation extending into the medium term, given the broad-based weakness in the real economy and subdued monetary dynamics."

To contrast the sharp change in policy from the ECB, the previous statement from June read, "The accommodative stance of our monetary policy, together with the significant improvements in financial markets since mid-2012, should contribute to support prospects for an economic recovery later in the year. Against this overall background, our monetary policy stance will remain accommodative for as long as necessary." The inclusion of the phrase relating to an extended period of accommodative policy was a sharp change in tone and reassured markets that the ECB will keep rates lower for some time.

As did the BoE, the ECB successfully convinced the market that rate hikes are far off in the distance and the ECB even hinted that rates could go lower. Draghi reiterated that the ECB is "technically ready" for negative deposit rates if it deems the policy prudent.

The economics team at Credit Suisse said that ECB forward guidance "was a big first step away from ‘never pre-committing' [to policy] but the ECB avoided the controversial question of the exact conditions it will base its forward guidance on. However, ECB President Draghi went a long way to explain how forward guidance fits the ECB mandate of maintaining price stability."

Markets React

European equities gained sharply on the news before giving back some gains Friday. However, the real news was in currency markets as traders priced in both the risk of less Federal Reserve easing through tapering of purchases and more easy-money policy from the two European central banks. The EUR/USD dropped below 1.30 on the news and fell as low as 1.2806 Friday morning while the GBP/USD rate broke through the key 1.50 level to an intraday low of 1.4858.


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