Central Bank Forward Guidance: Handle With Care
— Published on September 5, 2024
- Central banks use forward guidance about the future direction of their policy interest rate to enhance the effectiveness of monetary policy.
- Monetary policy works not only by influencing short-term interest rates but also by affecting expectations of future short-term rates and thus the yield curve, asset prices, economic activity and inflation. Forward guidance can usefully shape these expectations if used appropriately.
- Central banks increased their use of forward guidance during the Great Recession and the COVID-19 pandemic. Some observers have criticized its use during the pandemic, arguing it contributed to the sharp rise in inflation.
- Central banks used extraordinary forward guidance in these two episodes of severe economic downturns to provide additional monetary policy stimulus when policy interest rates were constrained by their effective lower bound (ELB). Such extraordinary forward guidance entails the central bank providing a commitment to hold the policy rate at a low level for a prolonged period.
- Extraordinary forward guidance can be effective in providing additional monetary stimulus by putting downward pressure on yields, but must be implemented in a flexible and nimble manner.
- There is a trade-off between the flexibility of the forward guidance commitment and its impact. Some central banks did better than others in managing this balance during the pandemic. Transparent communications about forward guidance can increase its credibility and improve this trade-off.
- Forward guidance should be the preferred monetary policy tool for use during a severe economic downturn; it is more flexible and has fewer legacy effects than other extended tools, such as quantitative easing.
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