Central bank ‘forward guidance’—a valuable tool when used wisely

Many observers have criticized the Bank of Canada, the U.S. Federal Reserve and other central banks for providing excessive monetary stimulus during the COVID-19 pandemic, causing inflation to spike to levels not seen in 40 years and well above the central banks’ two per cent target. This rise in inflation created an affordability crisis as the incomes of many households failed to keep pace with rising prices, especially for food, energy and housing.

To support demand for goods and services during the pandemic, central banks first reduced their policy interest rates to near zero, or in some cases, negative levels. They also resorted to unconventional monetary policy tools to provide additional stimulus including large-scale purchases of government bonds (or quantitative easing) and extraordinary “forward guidance”—an explicit commitment to hold the policy interest rate low for an extended period.

On Wednesday, the Bank of Canada again lowered its policy rate, making it three cuts in a row, as inflation continues to decline toward the two per cent target. Because the Bank used this forward guidance flexibly during the pandemic, it was able to begin the interest rate cycle of increasing and then decreasing its policy rate before other central banks such as the Federal Reserve.

Central banks have used forward guidance to inform financial market participants and the general public about the future direction of their policy interest rates to enhance the effectiveness of monetary policy, which not only influences short-term market interest rates but also affects expectations of future short-term rates and thus the yield curve, asset prices, economic activity and inflation.

Central banks have typically used more open-ended “Delphic” forms of forward guidance—named after the Oracle of Delphi in Greek mythology who prophesied about future events. However, during the severe economic downturns of the 2008-09 Great Recession and the 2020-21 pandemic, central banks used stronger forms of forward guidance to support the recoveries. And they made “Odyssean” commitments—named after the mythical hero who tied himself to the mast of his ship to resist the Siren’s song—to hold their policy rates at low levels for a specified period of time or until they sustainably achieved their inflation or employment targets.

But the fundamental challenge with this approach is managing the trade-off between the flexibility of the forward guidance commitment and its impact. Flexibility is important because economic conditions may evolve differently than what the central bank expected, and it might need to adjust its policy interest rate accordingly. But at the same time, more flexible forward guidance weakens the bank’s perceived interest rate commitment and thus reduces its impact.

Some central banks managed this balance between flexibility and impact better than others during the pandemic. For example, from 2020 and well into 2021, the U.S. Federal Reserve and the Reserve Bank of Australia maintained commitments to hold their policy rates at a very low level until 2024, and consequently were slow to raise their policy rates.

The Bank of Canada, however, shortened the horizon of its forward guidance over 2020-21 as the economy recovered faster than expected. Nonetheless, because of the stronger-than-predicted recovery and the unexpected price shocks caused by global supply chain bottlenecks and the Russian invasion of Ukraine, the Bank was obliged to rapidly increase its policy rate over the course of 2021 to lean against the resulting inflationary pressure and limit any increase in inflation expectations.

What’s the main takeaway?

Based on recent experience, extraordinary forward guidance is a powerful tool in the event of a severe economic downturn, especially when the policy rate is at or near zero. But it should be employed in a flexible manner. In fact, well-implemented Odyssean forward guidance may be the best monetary policy tool in such circumstances because it’s easier to use and has fewer legacy effects than other unconventional tools. For example, quantitative easing substantially increased the size of central banks’ balance sheets and had adverse effects on government fiscal positions. These impacts will take years to unwind, potentially leaving central banks with less policy room to respond when the next crisis hits.

The Bank of Canada recently announced a panel of experts to assess the bank’s internal review of the policy actions it took during the pandemic, including extraordinary forward guidance. The panel should not only assess the pluses and minuses of the various tools, but also consider the need for a transparent framework for their future use.