Key Takeaways
- Forward guidance is a central bank’s communication about future monetary policy.
- It aims to influence financial decisions and guide interest rate expectations.
- Central banks like the Fed use forward guidance to prevent market surprises.
- Forward guidance helps stabilize financial markets and boosts confidence.
- The Fed has used forward guidance since the Great Recession to keep rates low.
What Is Forward Guidance?
Forward guidance is a communication tool used by central banks such as the Federal Reserve, the Bank of England, and the European Central Bank to share their economic outlook and signal the likely path of monetary policy.
It aims to shape expectations about interest rates and the conditions that could prompt a policy shift, which helps households, businesses, and investors make financial decisions and reduces the risk of market surprises.
How Forward Guidance Influences Financial Decisions
Forward guidance attempts to influence the financial decisions of households, businesses, and investors by providing a guidepost for the expected path of interest rates. The central bank’s clear messages to the public are one tool for preventing surprises that might disrupt the markets and cause significant fluctuations in asset prices.
Forward guidance is a key tool of the Federal Reserve (Fed) in the United States. Other central banks, such as the Bank of England (BOE), the European Central Bank (ECB), and the Bank of Japan (BOJ), use it as well.
Important
Almost all recent Fed chairs, including Ben Bernanke, Janet Yellen, and now Jerome Powell, have been strong proponents of forward guidance. However, before the long tenure of Alan Greenspan, the Fed was far more reticent about telegraphing its intentions into the market.
Mechanics of Forward Guidance in Monetary Policy
Forward guidance consists of telling the public not only what the central bank intends to do but what conditions will cause it to stay the course and what conditions will cause it to change its approach.
For example, in early 2014, the Fed’s Federal Open Market Committee (FOMC) said it would continue to keep the federal funds rate at the lower bound at least until the unemployment rate fell to 6.5% and inflation increased to 2% annually. It also said that reaching these conditions would not automatically lead to an adjustment in Fed policy.
Advantages of Forward Guidance for Markets and Individuals
With some sense of where the economy might be headed, individuals, businesses, and investors can have greater confidence in their spending and investing decisions. Also, forward guidance can help the financial markets function more smoothly. For example, if the FOMC indicates it expects to raise the federal funds rate in six months, potential home buyers might want to get mortgages ahead of a potential increase in mortgage rates.
Important
During the FOMC meeting on March 15-16, 2022, the Fed increased interest rates in an effort to combat rising inflation. The Fed’s target range was increased by .25% (or 25 basis points), for the first time since 2018—going from 0% to .25% to .25% to .50%.
Case Study: Forward Guidance by the Federal Reserve
In the U.S., the Fed’s FOMC has used forward guidance as one of its major tools since the Great Recession.
Through the use of forward guidance, the FOMC has communicated its intent to keep interest rates low for as long as needed to improve credit availability and stimulate the economy. Similarly, Fed Chair Jerome Powell communicated to the financial markets that the Fed would continue to support the U.S. economy until the effects of the global financial crisis have subsided.
The Bottom Line
Forward guidance is how central banks such as the Federal Reserve and the European Central Bank signal their economic outlook and likely policy path to shape rate expectations.
It helps reduce market surprises and supports planning, as seen during the Great Recession when the Fed used clear messaging about keeping rates low and tying future moves to economic conditions.