Big guns home in on inflation targets

Two of the big guns in global central banking announced their monetary policy decisions overnight. The European Central Bank surprised no one leaving interest rates unchanged, as did the Bank of England.

While there was nothing to surprise the markets with the ECB decision, the surrounding statement, including the press conference from President Mario Draghi, did provide some chunky news on just how the ECB is viewing recent economic trends, the strength of the euro and the progress of normalisation in the government bond markets within the eurozone.

What got most attention were comments from Draghi that the recent strength of the euro was unwelcome, and was a potential threat to the recovery in the eurozone. Draghi was questioned in detail about the suggestion earlier this week from French President Francois Hollande that the eurozone move to manage its exchange rate more actively. Hollande, when noting the negative impact on the French economy from the higher euro, went so far as to suggest that the exchange rate policy be designed to limit "irrational movements” in the euro.

At his press conference, Draghi emphasised that the ECB was not acting to specifically influence the level of the euro and even made the point that "the appreciation is, in a sense, a sign of return of confidence in the euro." The fact that the economy was showing signs of bottoming and its markets were strong lent weight to that assessment.

"The exchange rate is not a policy target, but it is important for growth and price stability and we certainly want to see whether the appreciation is sustained and will alter our risk assessment as far as price stability is concerned," Draghi noted.

Draghi emphasised that the strong euro was forcing the inflation rate to fall, noting that "we'll certainly want to see whether the appreciation, if sustained, will alter our risk assessment as far as price stability is concerned." The updated forecasts from the ECB confirmed its expectation that inflation would fall below the 2 per cent target later this year and that this would give it scope to cut interest rates from the current 0.75 per cent.

The net effect of all of this discussion on the currency was a sharp fall in the euro. It dropped from just over 1.36 to the US dollar yesterday, to below 1.34 in early Australian trade.

The Bank of England not only held rates steady at 0.5 per cent, but also left its level of quantitative easing unchanged at £375 billion pounds. Unfortunately, the BoE did not provide any commentary or analysis of why it left the current stance of policy unchanged. Details of the decision will be released with the bank's inflation report, which is due next week.

That said, there was plenty of news to digest about the future direction of the BoE, with governor designate and former Bank of Canada Governor, Mark Carney, answering questions from the Parliamentary Treasury Select Committee.

Carney, who starts a five-year term as BoE Governor in July, noted a range of policy issues and priorities. In particular, he touched on the relative success Canada had with its flexible target for inflation, noting that when he takes up the governorship of the BoE, "details need to be reviewed and could be changed”. That said, Carney did concede that "in my view, flexible inflation targeting – as practiced in both Canada and the UK – has proven itself to be the most effective monetary policy framework implemented thus far.”

In speeches late last year, Carney had spelled out the merits of central banks targeting nominal GDP growth, a move that adds the real economy to inflation when monetary policy is set.

When quizzed on the possibility of changing the current BoE inflation target of 2 per cent, Carney was dismissive, saying "moving opportunistically to a higher inflation target would risk de-anchoring inflation expectations and destroying the hard-won gains that have come from the entrenchment of price stability".

The markets appeared to welcome Carney's comments, with the British pound rising around 0.5 per cent against a significantly stronger US dollar.