Forward guidance is a tool used by a central bank to try and influence market expectations of future levels of interest rates.
“Forward guidance” in monetary policy means providing some information about future policy settings.
The communication about the future path of policy rates is known as “forward guidance”.
This is done by central banks publicly providing their own thoughts on the state of the economy and on what their likely future course of monetary policy will be.
Instead of trying to telegraph or guess what the central bank will do next, they just straight up tell you!
That’s forward guidance.
If someone tells you ahead of time that he’s going to punch you in the face, that’s also a form of forward guidance.
But back to central banks…
An example is when central bank officials release their own interest rate forecasts, as a way to provide a guidepost for the expected path of interest rates.
In the current post-COVID19 world, forward guidance is nothing more than a central bank like the Fed or ECB saying it does not expect to raise interest rates for a period of time.
The purpose of providing “forward guidance” about the future policy to try and influence current financial and economic conditions.
Individuals and businesses will use this information to make decisions about spending and investments.
The central bank’s clear messages to the public are one tool for minimizing surprises from monetary policy that might disrupt the financial markets and cause significant fluctuations in asset prices like stocks, bonds, commodities, and currencies.
Forward guidance was popularized by Federal Reserve in the United States. The Federal Open Market Committee (FOMC) began using forward guidance in its post-meeting statements in the early 2000s.
Before increasing its target for the federal funds rate in June 2004, the FOMC used a sequence of changes in its statement language to signal that it was approaching the time at which a tightening of monetary policy was appropriate
During the Great Recession, the FOMC reduced its federal funds rate target nearly to zero and then used forward guidance by communicating that it would keep interest rates low for as long as needed in order for the economy to recover.
Nowadays, a lot of central banks do it, such as the European Central Bank (ECB) Bank of Japan (BoJ), Bank of England (BoE), Bank of Canada (BoC), Reserve Bank of Australia (RBA), Reserver Bank of New Zealand (RBNZ), and the Swiss National Bank (SNB).
What’s the Purpose of Forward Guidance?
Forward guidance and quantitative easing (large-scale asset purchases) are the two main unconventional monetary policy tools used to provide further monetary accommodation at the ZLB.
During the GFC, these tools were used together and may have worked in complementary ways.
For example, quantitative easing (“QE”) can convey information about the future path of the policy interest rate (the “signaling channel”), reinforcing the effect of forward guidance.
The credibility of forward guidance is strengthened if the central bank has also embarked in QE.
Many central banks have used forward guidance in recent years to influence interest rate expectations, particularly when rates are at the effective or zero lower bound (ZLB) or close to it.
Forward guidance is also seen as a useful tool for promoting a smooth adjustment when central banks are seeking to return policy rates to normal levels.
Beyond clarifying the central bank’s policy reaction function, forward guidance might cause market interest rates to be less sensitive to economic news if market participants take it as a firm commitment to follow a certain policy path.
But if rates are already at or close to zero, measuring this effect is a challenge: market interest rates could be less responsive to news simply because monetary policy is constrained by the ZLB.
Forms of Forward Guidance
Forward guidance can take different forms.
It can be open-ended.
For example, a central bank might announce that “Interest rates are expected to remain low for an extended period”.
It can entail more concrete conditionality in terms of timing (date-dependent).
For example, “Interest rates are expected to remain at present levels at least through the fall of next year”.
It can be in terms of economic developments (state-dependent).
For example, “Current policy is anticipated to be appropriate at least as long as the unemployment rate remains above 5.5%”.
Forward guidance can be quantitative or qualitative, depending on whether it provides specific figures or not.
Whatever its form, forward guidance can influence public perceptions about the monetary policy reaction function and policy commitment, and thereby influence market prices and economic outcomes.
The guidance could be more or less specific, but any perception that policymakers might renege on a prior commitment could undermine credibility.
This is why flexibility, and hence conditionality, is an important part of any forward guidance.
An unconditional commitment can tie a central bank’s hands too tightly.
If economic conditions warrant a deviation by the central bank from the stated path, the resulting damage to the central bank’s credibility could hurt its effectiveness over the long term.
All forms of forward guidance thus face a trade-off between the strength of the statement and flexibility.
Unequivocal statements, by specifying more restrictive conditionality (for example, a clear date or threshold when the policy rate will be changed), signal a stronger and clearer policy intention.
Thus, date-dependent forward guidance is arguably more constraining than the state-dependent variety, especially if the latter has many qualifications attached.
State-dependent guidance offers more flexibility to respond to changing economic conditions, but may have a weaker impact on expectations, especially if the criteria for policy moves are viewed as subjective or qualitative.
A key advantage of more restrictive conditionality is that it gives the central bank more influence over market prices.
In some cases, a central bank may want markets to be less sensitive to economic developments, such as during a period of heightened downside risks.
During an easing phase, this can help a central bank maintain and strengthen the degree of policy accommodation.
And in the early stages of normalization, a more restrictive approach can help pin down market expectations, making for a more gradual adjustment in financial conditions.
In this sense, some effect of forward guidance on market reactions to news may be intentional.
At the same time, restrictive conditionality could engender market complacency.
Market participants may place too much confidence in previous guidance even as circumstances change, and take on greater risk based on the wrong assumptions.
For central banks, this can make it harder to deviate from what they have previously announced for fear of creating market turbulence and damaging credibility.
And the more central banks “whisper”, the more market participants may lean in to hear and react to even small shifts in nuance.
When a change in the policy stance becomes inevitable, the market adjustment will then be all the more violent.
These considerations suggest that one way of assessing market perceptions of the central bank’s commitment to its forward guidance is to look at market reactions to economic news.
The stronger the perceived intention to adhere to a certain policy rate trajectory (more restrictive conditionality), the more muted the response of market prices to the news.
How Can Forward Guidance Affect the Economy?
Conventional monetary policy primarily influences the economy through its effects on interest rates.
Interest is what you pay for borrowing money, and what banks pay you for saving money with them.
Interest rates are shown as a percentage of the amount you borrow or save over a year. So if you put $100 into a savings account with a 1% interest rate, you’d have $101 a year later.
Different central banks have different names for their “official” interest rate.
For the U.S, it’s called the federal funds rate. For the U.K, it’s called the base rate. For Australia and New Zealand, it’s called Official Cash Rate (OCR).
A change in interest rates shifts the expectations of future monetary policy which, in turn, affect long-term interest rates.
These long-term interest rates, such as those on auto loans and mortgages, are most relevant to households’ spending decisions.
Through this channel, then, a reduction in the interest rate is able to promote spending in the economy and which increases price pressures for companies as they begin to use resources more intensively to meet the higher demand.
In the U.S, when the federal funds rate was lowered to almost 0%, it hit its “lower bound”, which is just a fancy way of saying that it can’t go any lower.
When this happens, reducing the interest rate further is no longer able to generate economic stimulus.
Basically, the conventional monetary approach stops working. And now you need an unconventional monetary approach.
This is where forward guidance comes in.
Forward guidance operates through a similar interest rate channel but does NOT require a change in the current target federal funds rate.
When the FOMC issues statements that policy rates will remain exceptionally low in the future, this reduces both components of long-term rates, the term premium, and the expected path of future interest rates.
This type of policy guidance reduces the term premium by reducing the risk of future policy rates unexpectedly increasing.
Consequently, investors buying a long-term bond will require a lower term premium, which is the additional compensation they require to bear the risk of future short-term rates differing from their expected path.
A lower term premium can stimulate the economy by lowering the credit premium on private debt, which decreases borrowing costs for businesses and households.
Forward guidance can also lower long-term interest rates by lowering the expected path of short-term interest rates.
Past policy actions suggest that when the economy slows, the Federal Reserve will lower future policy rates to stabilize the economy.
When the policy rate is at its effective lower bound, however, future policy rates can’t be lowered further.
Instead, the FOMC can issue statements about how long the target federal funds rate will remain exceptionally low.
If the announced duration of low-interest rates is longer than the public expects, a fall in the future path of interest rates then causes an immediate decline in longer-term rates.
But whether this change in policy stimulates the economy depends on how the public interprets the forward guidance.