Pricing the ECB's forward guidance with the EONIA swap curve

• Author: Matthieu Picault
• Published date: 01 April 2017
• Date: 01 April 2017
• DOI: http://doi.org/10.1002/ijfe.1572

Received: 29 July 2015 Revised: 4 July 2016 Accepted: 23 November 2016

DOI 10.1002/ijfe.1572

RESEARCH ARTICLE

Pricing the ECB’s forward guidance with the EONIA swap curve

Matthieu Picault1,2

1IESEG School of Management, 3 rue de la Digue

Lille, 59000, France

2Aix-Marseille University, France

Correspondence

Matthieu Picault, IESEG School of Management, 3

rue de la Digue, Lille 59000, France.

Email: m.picault@ieseg.fr

JEL Classification: E52; E58; G14

Abstract

On July 4, 2013, following several other major central banks, the European Central

Bank (ECB) gave forthe first time forward guidance on interest rates, which affected

market participants’ expectations of future interest rates in the context of a Zero

Lower Bound. Using an ARMAX(1,1) model in which the effect of the commu-

nication of negative macroeconomic news was disentangled from the commitment

positive shock, the impact of the forward guidance on money market interest rates

is estimated through the Euro Overnight Index Average swap, also called overnight

index swap, at maturities between 2 months and 10 years using abnormal returns

from an event study. The results and robustness checks suggest that the ECB’s guid-

ance lowered overnight index swaprates for maturities within 10 mont hs to 3 years.

These results imply the existence of a commitment effect from the ECB’scommuni-

cation. In the context of decreasing market liquidity because of the 3-year long-term

refinancing operation repayment, market participants priced the low period of

interest rates until mid-2016.

KEYWORDS

ECB, event study, forward Guidance, LTRO, monetary Policy, OIS

1INTRODUCTION

Already used by several central banks (New Zealand since

1997, Norway since 2005, Sweden since 2007, and the Czech

Republic since 2008)1as a standard monetary policy tool, the

forward guidance from the European Central Bank (ECB) and

other major central banks, such as the Federal Reserve, the

Bank of Japan, and the Bank of England, appears in the con-

text of a Zero Lower Bound (ZLB) of nominal interest rates.

On July 4, 2013, the ECB gave for the first time in its exis-

tence forward guidance during a press conference by stating

that “The Governing Council expects the key ECB interest

rates to remain at present or lower levels for an extended

time.” This communication was used after the implemen-

tation of balance sheet policies with both quantitative (the

Covered Bond Purchase Programme, the Securities Markets

Programme, and the fixed-rate full allotment for the main

refinancing operations) and qualitative easing (a change in

the maturities of long-term refinancing operation (LTRO)

programs)2.

The forward guidance relative to the interest rate is a com-

munication by the central bank using an explicit statement

about the outlook for future policy rates (Woodford, 2012). By

influencing expected short-term rates, the central bank could

affect in the same direction long-term yields. As the central

bank committed to a future path of policy rates for an impre-

cise or specific time, market participants would adjust their

anticipations of future short-term interest rates. Following the

expectations hypothesis of the interest rate term structure, the

central bank could then influence longer-term yields. This

type of guidance is called “Odyssean” by Campbell, Evans,

Fisher, and Justiniano (2012) as it ties the central bank to

a given future behavior. A commitment implies that regard-

less of macroeconomic developments, the central bank will

maintain the interest rate at a given level (close to the Zero

Lower Bound). However, a commitment might also imply

considering the central bank loss function (see Svensson

(1997) for a quadratic form), a short-term loss for the central

bank as inflation and the output gap deviate from their tar-

gets, while monetary instruments (main policy rates) remain

unchanged. Hence, the central bank will cloud its long-term

objectives as the economic variables deviate from the cen-

tral bank’s objectives. When implemented, the forward guid-

ance is then subject to time-inconsistent decision making

Int J Fin Econ. 2017;22:129–138. wileyonlinelibrary.com/journal/ijfe Copyright © 2017 John Wiley & Sons, Ltd. 129