How will the ECB's forward guidance evolve? - BBH

"The record from last month's ECB was read particularly hawkishly by market participants. The euro and interest rates jumped. The focus apparently was on a couple of lines suggesting that the forward guidance will likely change early this year," BBH economists argue.

Key quotes

The market reacted like this was new news, and we suspect that many ECB officials were surprised by the market reaction.  We think comments by Draghi, who takes pains to be clear about what was and wasn't discussed, at the press conference delivered essentially the same message.   

More market participants began talking about an ECB rate hike this year. We think it is far-fetched, and before the weekend Bundesbank President Weidmann cautioned against the rate hike speculation.  Recall too the meeting was before the December flash CPI reading, which disappointed (core rate was unchanged at 0.9%), and it will likely be confirmed when the report is out in the coming days. The ECB's record was indeed upbeat but was also clear that inflation continued to undershoot, and that is was committed to the sequence of finishing asset purchases and then, after some time, lifting rates.   

If anything, the strong euro will dampen inflation pressures and squeeze earnings.  Anglo-American companies are more likely to pass along currency developments to customers, while Continental and Japanese businesses appear to put more emphasis on market share than short-term profitability, are less likely.  The rule of thumb is that a 6% appreciation on a trade-weighted basis has the equivalent impact of 100 bp tightening on economic conditions.  The euro's 2.5% appreciation on a trade-weighted basis is tantamount to a 40 bp tightening of monetary policy.      

How will the ECB's forward guidance evolve?  The ECB record was clear.  The vast majority do not want to delink inflation from the asset purchases.  Announcing firm date-end to the purchases, as some of the hawks have argued, will, in fact, delink the two.  The policy would become date-dependent, not data-dependent.   Instead, a more likely course, we suspect is providing some guidance about the other components of ECB's unconventional monetary policy.   

Recall too that starting near mid-year, European banks can repay the TLTRO borrowings early.  They had borrowed around 750 bln euros.  A small, say 10%, early prepayment would offset 2 1/2 months of ECB purchases, and spur a reduction of the ECB's balance sheet just as officials begin to provide guidance of what is going to happen at the end of September when the 30 bln a month of purchases is to conclude.