What in the World is Forward Guidance?!

Based on the latest rate statements, “forward guidance” seems to be in vogue among central bankers. In this edition of Piponomics, I will discuss the what, when, who, why and how questions concerning this new trend in policy statements!

What is forward guidance?

Forward guidance is a kind of communication strategy practiced by central bank officials wherein forecasts for interest rates and monetary policy are publicly disclosed during their rate statements.

When did this trend start?

Folks over at the U.S. Federal Reserve have adopted this kind of communication strategy by giving interest rate forecasts before the term “forward guidance” even existed. Big Ben is a hipster, if you ask me!

A few years back, Fed head Bernanke often spoke of keeping interest rates at record lows for an extended period. To this day, Bernanke continues to practice forward guidance by giving a time frame of when the US central bank plans to reduce their bond purchases.

Who else has tried it out?

Last week, new BOE Governor Mark Carney and ECB Governor Mario Draghi both decided to give forward guidance a shot.

In his first speech as the BOE head, Mark Carney declared that markets shouldn’t expect an interest rate hike within the next couple of years. Meanwhile, ECB head Draghi borrowed one of Bernanke’s favorite phrases by saying that euro zone interest rates would remain low for an extended period.

Why did the central bank heads decide to practice forward guidance?

There are two main benefits to practicing forward guidance. First, it allows policymakers to control the volatility in bond yields and borrowing costs. By giving market watchers an idea of how long they plan to keep interest rates unchanged, central bankers are able to reduce speculations surrounding lending rates and the price spikes that often result from these.

Second, it allows policymakers to make the most out of their current monetary policy. Remember that several central banks have already lowered their interest rates close to zero and that they are running out of options for further easing. By pledging to keep interest rates low for an extended period, they can influence banks and lending institutions to set lower borrowing costs even for longer-term loans without having to push actual benchmark rates any lower.

How can it affect forex price action?

Judging by the immediate reaction to the rate statements by the BOE and ECB, it seems that this forward guidance trend could make huge waves in the forex market.

In particular, central banks that specified their plans to keep monetary policy loose for the foreseeable future were able to induce heavier selling pressure on their respective currencies. This could mean stronger and longer-term trends for pairs such as EUR/USD and GBP/USD, especially since the Fed is on a completely different page as it plans to taper stimulus towards the end of the year.