What Is Central Bank Forward Guidance?

Forward guidance is a more unconventional policy tool but can be highly affective in achieving policy goals.
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We have a quick question here from Chris asking “What exactly is central bank forward guidance?” So, thanks for the question, Chris.

Forward guidance is one of the many tools that central banks can use to achieve their policy goals. The more conventional tools are obviously changing short-term interest rates and on the more unconventional side we have things like quantitative easing and forward guidance, however, arguably after the global financial crisis, just take that squawk down, arguably after the global financial crisis, forward guidance has arguably become a more conventional tool used by central bank.

What is forward guidance? It’s basically the central bank achieving certain policy outcomes by using their words, without actually sometimes having to really do anything.

For example, imagine you have a central bank that has cut interest rates down to zero and has started a QE program, but they also want to ensure that commercial banks keep rates low for their customers for a long time. They can achieve lower rates across the board throughout banks if banks believe then that rates will stay low for long.

So, if they say that rates will stay lower for longer, they can say something like, rates will stay at these very low levels for an extended period of time or until the bank sees clear economic recovery. Now, that would be an example of forward guidance.

So, it’s the bank’s way of both preparing the market for possible future policy actions and also achieving certain outcomes without sometimes even doing anything. There’s also a difference between the types of forward guidance. So, you can get more qualitative as well as more quantitative forward guidance.

The bank might say something like rates are going to stay low at least until the end of 2021. Now, that would give you a more quantitative forward guidance because you know rates will stay lower at least until that specific date. Or, they might say something like rates will stay low until inflation returns to target and the economic growth recovers. That would be a more conditional forward guidance and qualitative to some extent because there’s no way in knowing how long that will take and what the bank will deem as growth having recovered. What is the matrix that we’ll use?

So, that’ll be a more qualitative and a more conditional forward guidance. Sometimes the banks, as we say, can achieve a policy outcome without needing to actually do it. For example, a central bank can say that negative interest rates are not something that they will do immediately, but it is something that remains on the table and we’ll be ready to deploy it if the economic situation warrants it. Now, even if the bank never goes to negative interest rates, the forward guidance that negative rates might be possible can sometimes be enough to achieve lower rates just by making that type of statement.

Now, of course, this can only work when the market believes what the bank says, right? So, it can only work when the central bank has credibility and credibility will determine whether a central bank can use forward guidance as an effective tool or not.

And a good example of this would be the difference between something like the Federal Reserve and the Swiss National Banks. If the Fed says that they are going to do something, or will probably do something, the market will usually take their word for it because they have credibility.

So, they normally follow through with their actions or with their words. By comparing that to the S&P, the markets don’t always believe what the S&P has to say, especially after they caused that massive issue a couple of years back by basically saying that they will keep the 120 peg for the Euro Swiss in place and just a few weeks later they basically removed the peg overnight without giving the markets any warning which caused a massive, massive appreciation in the Swiss franc across the board and caused many traders and brokers to go bankrupt due to that particular move.

For a bank like the Swiss National Bank, forward guidance might not be a tool, it might be a tool that they use, but it won’t really be effective because the markets don’t really believe what they have to say especially if you compare it to something like the Fed, or the ECB, or the BoC, or the RBA et cetera. So, Chris, I hope that helps. Any other questions, just let us know.

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