The main takeaway from today’s European Central Bank meeting is that low inflation and the volatility in money market rates are becoming a bigger headache for the central bank. While the ECB left interest rates unchanged, the euro sold off when central bank President Draghi said they strengthened their forward guidance. In addition to saying that “interest rates will remain at present or lower levels for an extended period of time,” Draghi warned that they would “act if the inflation outlook worsened” or “money markets tightened.” This enhanced forward guidance leaves the ECB with a slightly more dovish stance which explains why EUR/USD dropped to a fresh 1 month low on the back of Draghi’s comments. However the currency pair has not extended its losses beyond 1.3548 (so far) because Mario Draghi did not suggest the central bank has grown more serious about moving into uncharted territory by dropping interest rates below zero. All policy tools are at their disposal and they stand ready to act if needed but right now they are comfortable with the current level of monetary policy.

ECB President Draghi spent most of his prepared comments talking about low inflation. He barely acknowledged the momentum in Germany’s economy and simply said incoming data confirms the ECB’s previous assessment and warned that growth risks remain “on the downside.” It seems that Draghi is not impressed by the positive surprises in German data because the rest of region is still growing slowly. He described the economy as weak and said output should recover at a slow pace in 2014 and 2015. With inflation expected to remain low for at least the next 2 years, interest rates will remain at the present or lower level for an extended period. However in order for monetary policy to be eased again, the inflation outlook needs to worsen or money markets need to rise.

It can be argued that nothing new came out of today’s ECB press conference because the bar is high for negative rates, but the fact that ECB enhanced its forward guidance means they strengthening their dovish bias at a time when the Federal Reserve is hardening its commitment to tapering asset purchases. The improvement in jobless claims reinforces the positive outlook for the U.S. economy and labor market. We are still looking for the EUR/USD to drop to 1.35 in the near term and 1.33 over the medium term. The following chart shows how 1.35 is not only a psychologically significant level but also the 50% Fibonacci retracement of sell-off between 2011 and 2012.

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