Forward guidance

The term "forward guidance" refers to a central bank's public announcements about the likely future path of its short-term interest rates. Such announcements are made with the intention of affecting long-term interest rates by influencing the expected short-term rates (spot rates) at given maturities along the yield curve.

Forward guidance provides economic agents with an indication of the likely future level of the short-term rate of interest (the federal funds rate in the United States), which the central bank controls directly. This, in turn, allows these agents to form expectations of the rate of interest at which banks will be able to borrow overnight funds from the central bank in the future. Qualitative forward guidance aims to steer interest rate expec- tations by, for example, providing likely triggers or thresholds to interest rate moves, often the emergence of specific economic conditions. Quantitative forward guidance offers explicit numeric forecasts of interest rates for a given number of periods into the future. The US Federal Reserve moved from qualitative to quantitative forward guidance in December 2012, when it indicated that the prevailing federal funds rate of 0-¼ per cent would be maintained at that level as long as the unemployment rate exceeded 6½ per cent and one- to two-year inflation projections remained below 2½ percentage points.

The theoretical foundation of forward guidance lies in the expectations hypothesis of the term structure of interest rates, which posits that the long-term rate of interest is determined by the market expectations for short-term interest rates over the given invest- ment horizon plus a risk premium. However, empirical studies challenge this theory, showing that while long-term rates of interest reflect the market's expectations of future short-term interest rates, actual future interest rates follow a random walk and are thus essentially unpredictable (Guidolin and Thornton, 2008).

Advocates of forward guidance promote the view that transparency improves efficiency of central bank policy. At the root of this argument is the idea of optimal monetary policy inertia, which states that small but persistent alterations in the short- term interest rate - rather than less predictable, more drastic adjustments of this rate in response to changes in economic conditions - permit the monetary authorities to exert a greater influence on long-term policy rates of interest and thus on total demand (Woodford, 1999).

The theoretical transmission channels of this monetary policy tool may be conflict- ing. Indeed, a central bank announcement of low future rates of interest may be inter- preted by economic agents as a commitment to continued monetary stimulus, arguably associated with higher expected future inflation rates and hence lower expected real inter- est rates, leading to increased aggregate demand (Eggertsson and Woodford, 2003). Even in the absence of expectations for higher future inflation rates related to monetary stimu- lus, which is both theoretically and empirically questionable, economic activity may be boosted by the perception of improved future economic prospects, supported by accom- modative monetary policy. Alternatively, the same announcement may be interpreted as negative news on the state of the economy, based on information exclusively available to the central bank (Del Negro et al., 2012).

Forward guidance may thus be used for two distinct purposes, namely as a means of commitment to a specified path of interest rates or as a means of sharing information. In the case of the former, the gains from this policy instrument depend on the losses that are associated with the surrender of future flexibility and the costs of deviation from prior commitments. The optimal degree of commitment is likely to be variable over time and dependent on the particular economic and financial environment in which a central bank operates (Gersbach and Hahn, 2008). The costs of deviation are associated with the loss of central bank credibility, which may influence the future effectiveness of forward guid- ance and raise questions regarding the central bank's competence, whereas the surrender of flexibility may be problematic in the case of unexpected changes in macroeconomic conditions. Gersbach and Hahn (ibid.) question the usefulness of forward guidance as a method for sharing information, because a central bank is unlikely to issue forward guid- ance that reflects expected future economic or financial turbulence, and thus suffers from a credibility constraint.

Forward guidance may also have the negative impact of diverting market expectations from fundamentals and weakening the market's forecast capacity. Economic agents may overreact to public information at the expense of private information (Morris and Shin, 2002). Forward guidance announcements may also be misinterpreted. On 17 June 2013, when the US Federal Reserve Chairman Ben Bernanke announced that the Federal Reserve would begin "tapering" its asset-purchase programme around mid 2014, the news was interpreted as an implicit promise of tightening, which resulted in a sharp rise in interest rates at the long end of the yield curve (Harding and Politi, 2013). The break- down of traditional transmission mechanisms of monetary policy, most notably in the United States, puts in question the ability of the central bank to make accurate projec- tions of economic activity that justify its forward guidance, as such projections are made on the assumption that the expanding monetary policy toolkit will permit the central bank to effectively achieve its objectives.

See also:

Bank of England; Bernanke, Ben Shalom; Carney, Mark; Central bank credibility; Effective lower bound; Federal Open Market Committee; Monetary policy transmission channels; Random walk; Time inconsistency; Yield curve.