Forward guidance basically means that a central bank will tell the market as clearly as possible what its intentions are and what the time frame is for carrying out its mandate.
Why Central Banks use Forward Guidance
They like to give the markets and speculators lots of little clues and hints about what potential changes to the policy they will make and when they plan on making these changes. The idea is to minimize aggressive market reactions and control price volatility by stating their intentions over time rather than hitting the market all at once. They do this because the more known something is to the market the less violent the reaction will be when the data is released.
Forward guidance is verbal assurances from a country’s central bank to the public about its intended monetary policies. Forward guidance attempts to influence the financial decisions of households, businesses and investors by letting them know what to expect from interest rates to the extent that the central bank can influence those 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 in the United States. Other central banks, such as the Bank of England, the European Central Bank, and the Bank of Japan use it as well while other central banks choose not to offer it.
Forward Guidance Example
In the United States, the Federal Reserve’s Federal Open Market Committee (FOMC) has used forward guidance as one of its major tools since the Great Recession. Through the use of forward guidance, the FOMC intends to help interest rates remain low to improve credit availability and stimulate the economy in times of economic expansion.
Forward Guidance Distinction
Forward guidance consists of telling the public not only what the central bank intends to do, but what conditions will cause it to stay with its current mandates and what conditions will cause it to change its approach. This is a very important distinction to make with forward guidance.
For example, the FOMC in late 2013 and early 2014 said that 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 Federal Reserve policy. That is very specific information for the market to focus on and price the US Dollar when those changes start to take place.
Economic Impacts from Forward Guidance
With some sense of where the economy might be headed, individuals, businesses and investors can have greater confidence in their spending and investing decisions and financial markets may be more likely to function smoothly.
For example, if the FOMC indicates that it expects to raise the federal funds rate in six months, this means that potential homebuyers might want to get mortgages ahead of a potential increase in mortgage rates.
How Traders use Forward Guidance
With all the above in mind, one of the first places a trader’s research and analysis should take them is the central banks themselves. They release statements and forecasts regularly via their websites. Traders work hard to decipher these releases for clues about future monetary policy.
Often traders will focus heavily on certain words within the central bank release because these words or phrases are the things that are changed or replaced when policy is about to change.
For example, around the end of 2014, the Federal Reserve in its statement on monetary policy stated that it will likely wait for a “considerable time” before raising the interest rates. Traders in the market knew that when the economic conditions improved the Fed will at some point be forced to remove the “considerable time” wording from its statement. Sure enough, a few months later they removed that phrase and replaced it with saying they would be “patient” with beginning to normalize monetary policy. Normalizing monetary policy simply means that they are intending to bring interest rates back to a more historical percentage rate rather than being low forever.
This change may seem minor but to the markets, this was a subtle step towards rate hikes delivered in a way so as to not cause chaos in the markets. This is a very good example of how a central bank provides forward guidance and communication to the markets in tiny steps with any changes that it wants to make. This ensures that the markets are often expecting the moves before they actually happen and will significantly limit violent reactions in the markets.
By switching to the word “patient” the Fed allowed itself more flexibility regarding when the rate rise would actually come and communicated to the markets that a hike would only happen if the data supported such a move. A “considerable time” does not really allow for a hike within the next three months whereas if they are being “patient” they can hike at any point after the initial month following the change. This was a typical example of the types of word games played by central banks around the world.