Purpose of the article: This article aims to define the concept of forward guidance, explain the issues surrounding this monetary policy instrument, and present the mechanisms through which it influences real and financial variables. The article also highlights the complexity of this communication tool, both in its use by central bankers and in its interpretation by financial market participants.
Summary:
- Forward guidance is an unconventional monetary policy tool whose use has become widespread since the 2007-2008 financial crisis, alongside balance sheet policies (asset purchase programs and exceptional liquidity loans to commercial banks).
- This instrument consists of central banks communicating their future monetary policy, particularly with regard to the future trajectory of their key interest rates and the pace and amount of their future asset purchases or reinvestments.
- This tool is particularly delicate to use, as its effectiveness depends on how market participants interpret it. Central bankers must therefore take particular care to ensure that their commitments are credible and consistent over time.
- Studies seem to highlight the effectiveness of forward guidance in reducing long-term interest rates and uncertainty. The effects on economic activity are more difficult to assess, but several studies report stimulating effects.
Forward guidance is a communication tool available to central banks, consisting of providing information on their future monetary policy (Banque de France).
The adoption of this monetary policy instrument became widespread following the 2007-2008 financial crisis, which led central banks to reduce their key interest rates to a level close to or even equal to zero (Zero Lower Bound). As this interest rate policy proved insufficient to ease tensions on the financial markets and revive economic activity, the monetary authorities had to introduce new tools. These included asset purchase programs (or quantitative easing) and forward guidance.
The use of forward guidance is part of an evolving process in central bank communication, moving from a culture of secrecy to a desire for extensive communication (Banque de France). To illustrate this substantial change, we can quote Alan Greenspan’s words from 1988: « If you think I have been clear and unambiguous, I assure you that you have probably misunderstood me. »
In contrast, today, and for several years now, central bankers have been doing everything possible to clarify their policies and interact with the general public.
Blinder (2018) considers that forward guidance is now an integral part of the central banks’ toolkit. Therefore, even if the monetary authorities regain sufficient room for maneuver to use their key interest rates as the main instrument of monetary policy, they will continue to influence the markets through their communication on their future monetary policy strategies.
1) Definitions and theoretical foundations of forward guidance
1.1 Definitions and different classifications of forward guidance
Through their forward guidance policy, central banks convey information about their intentions regarding the most likely future path of short-term interest rates, in order to anchor the expectations of private agents and prevent upward pressure on medium- and long-term rates.
Under normal circumstances, the central bank acts on its key interest rate in order to influence the entire yield curve, with long-term rates having the greatest impact on investment and consumption and therefore on overall production. As the financial crisis led to a deterioration in the traditional transmission channels of monetary policy, forward guidance makes it possible to bring medium- and long-term rates closer to short-term rates.
Central bankers also use forward guidance to support other monetary policy measures such as asset purchase programs.
This instrument thus aims to clarify the central bank’s objectives and reaction function, but also to reinforce the accommodative nature of its monetary policy. It works when announcements including forward guidance are understood by market participants as a credible commitment to maintain monetary conditions that are more accommodative than would have been expected in the absence of forward guidance.
The ultimate objective of this policy is part of a communication strategy that aims to influence medium- and long-term price expectations in a sustainable manner, in line with the mandate of central banks (for the ECB, for example, an inflation rate below but close to 2%).
It is important to note that forward guidance is not an unconditional commitment to future central bank policies, as central banks necessarily react to new information, but it does provide clarity on how they incorporate this information (Benoît Coeuré, 2019).
Forward guidance can take different forms. Campbell (2012) proposes an initial classification, distinguishing between « Delphic » forward guidance and « Odyssean » forward guidance.
The former consists of a central banker communicating the likely path of monetary policy based on their expectations regarding the economic situation over their reference time horizon. Moessner et al. (2015) propose distinguishing between two types of « Delphic » forward guidance: interest rate forecasts provided regularly by the central bank as part of inflation targeting, and forecasts provided on the probable future action of their monetary policy on an episodic basis, in unusual circumstances (« Aesopian forward guidance »).
Odyssean forward guidance, on the other hand, specifies the central bank’s reaction function by clarifying the relationship between what might happen in the future and what the central bank would do in response to those changes. The effect of these announcements will depend heavily on how market participants interpret them.
Blinder et al. (2018) distinguish between three types of forward guidance:
(1) Qualitative: the central bank gives no indication of timing or conditions (e.g., « We expect the ECB’s key interest rates to remain at their current or lower levels for an extended period of time »).
(2) Data-driven: interest rate changes are based on macroeconomic variables such as the unemployment rate or inflation (e.g., « for as long as necessary to ensure the continued and sustained convergence of inflation to levels below, but close to, 2% over the medium term »).
(3) Calendar-based: the central bank announces a calendar for its future decisions on key interest rates (e.g., « Key interest rates are expected to remain at their current levels at least through the first half of 2020 ») or its purchase programs.
The above classification distinguishes between « quantitative » and « qualitative » forward guidance.
1.2 Underlying theoretical mechanisms
The first theoretical foundations of forward guidance date back to Krugman (1998), Reifschneider and Williams (2000), and Eggertsson et al. (2003). According to these authors, by ensuring transparency on the trajectory of future policy rates or future deviations from the economic policy rule, forward guidance shapes the expectations of economic agents. Thus, when the policy rate tends towards zero, monetary policy can be transmitted to the real economy via this forward guidance instrument.
This monetary policy tool influences various economic and financial variables (interest rates and therefore the financing of the economy, inflation expectations, and the exchange rate) through different mechanisms.
The effect of forward guidance is particularly evident in the term structure of interest rates. The theory of the term structure of interest rates assumes that long-term rates are a combination of anticipated future short-term rates and therefore that different maturities are perfectly substitutable, i.e., agents wishing to lend for n periods have no preference as to the maturity of their bonds.
By guaranteeing that key interest rates will remain low, central banks shape market expectations of future short-term rates, which will have a de facto effect on the forward-looking component of long-term rates if the commitment is deemed credible by market participants.
Forward guidance also affects the second component of long-term interest rates, the risk premium. By clarifying the future path of key interest rates, forward guidance reduces the volatility of market participants’ expectations, which translates into a lower risk premium demanded by investors for long-term financial securities. To a lesser extent, the conditional nature of forward guidance announcements on macroeconomic variables can help mitigate volatility risk and thus reduce long-term interest rates.
This flattening of the yield curve helps ease financial conditions and thus stimulates economic activity. Lower long-term interest rates directly boost aggregate demand by stimulating private consumption and investment, increasing the price of other assets, and reducing the value of the currency. In theory, the expected decline in key interest rates also indirectly stimulates aggregate demand by raising expectations of future output, and may indirectly lower real interest rates by increasing expected inflation.
However, forward guidance is complex and raises a number of concerns. First, the effectiveness of this instrument depends heavily on the credibility of central banks, even though this credibility may be threatened by poorly managed communication. This will be the case, for example, if monetary authorities have to substantially revise their forecasts for future key interest rates due to a significant and unexpected change in the macroeconomic environment.
It is therefore essential for central banks to strike the right balance between clarity and flexibility in their actions. This will also ensure consistency between their various actions and their medium- and long-term mandate.
Furthermore, there is a risk of misinterpretation by financial markets. Indeed, communicating the intention to keep key interest rates at zero for longer in order to increase the degree of policy accommodation may be misinterpreted as a sign of a more pessimistic economic outlook on the part of the central bank. In this case, forward guidance would have a negative impact on confidence rather than the intended stimulus.
The list is not exhaustive, but the third limitation presented is the risk of market price distortion. This could occur if market participants became dependent on monetary policy, relying solely on monetary policy announcements to buy or sell their financial assets, rather than on economic fundamentals.
2) Forward guidance in practice
2.1 Forward guidance practices of different central banks
Table 1: Main changes in the forward guidance strategy of the Federal Reserve (Fed) and the European Central Bank (ECB)
This forward guidance tool, initially introduced to compensate for reaching the zero lower bound, is now part of the central banks’ toolkit. This communication strategy must remain flexible and adaptable in order to best suit monetary policy objectives. Table 1 shows that the Fed and ECB’s forward guidance strategies have evolved significantly since their introduction. They continue to be adjusted to best meet the objectives of the central banks.
For example, the adoption of flexible average inflation targeting of 2%, announced by Jerome Powell in August 2020, led to a shift in the Fed’s forward guidance strategy. The Fed now signals that rates will remain unchanged until labor market conditions have reached levels consistent with the full employment objective and inflation has reached 2% and is on a path to moderately exceed that threshold for some time.
2.2 How effective is this monetary policy instrument?
Various studies evaluating the effects of forward guidance seem to highlight the effectiveness of this tool in reducing long-term interest rates and uncertainty. The effects on economic activity are more difficult to assess, but many studies nevertheless report stimulating effects.
Empirical analyses of the effects of forward guidance face technical constraints. Forward guidance announcements are made in conjunction with the announcement of other programs, making it difficult to isolate the effect of each of these measures.
With regard to the effects of this instrument on financial variables, several studies have shown that the prices of financial securities (bonds, stocks) fell following forward guidance announcements. Femia, Friedman, and Sack (2013) show that this price reduction is due to changes in market participants’ perceptions of the FOMC’s reaction function, and not just to changes in expectations of economic performance. Filardo and Hoffman (2014), Hubert and Labondance (2018), and Ehrmann et al. (2019) confirm these results for other central banks.
As for the effects of forward guidance on macroeconomic variables, theoretical and empirical studies have produced mixed results. Eggertsson and Woodford (2003) show, using a standard economic model with price rigidities, that lowering the expected path of policy rates can stimulate economic activity and increase inflation.
Conversely, empirical studies by Campbell et al. (2012) and Nakamura and Steinsson (2018) show that forward guidance announcements can lead to a contraction in economic activity. According to them, this is because markets interpret these announcements as a signal of a deterioration in the state of the economy.
There is a large body of research on the effects of forward guidance, but the results are very mixed. While it is difficult to draw conclusions about the nature of the impact of forward guidance on macroeconomic variables, it can be said that the effectiveness of this instrument depends very much on market interpretation and the nature of the forward guidance announcement.
Conclusion
Forward guidance can take different forms, which it is important to differentiate between. Furthermore, the effectiveness of this monetary policy instrument depends heavily on how it is interpreted by market participants. If they consider the announcement to be « Delphic » in nature, they will perceive the announced low interest rate trajectory as a sign of an unexpected deterioration in the state of the economy. Conversely, if they perceive it as Odyssean, they will interpret this announced low interest rate path as a period of even more accommodative policy and lower long-term real interest rates (see Andrade et al., 2019).
Central banks must therefore be extremely cautious in their use of forward guidance and, more generally, in their communications.
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