The end of forward guidance?

The Fed describes forward guidance as a ‘tool that central banks use to provide communication to the public about the likely course of monetary policy’. The Bank of England takes an even more straightforward approach: in March, Deputy Governor Ben Broadbent explained it in similarly prosaic fashion as ‘statements by monetary authorities about future policy’. 

By providing an indication of the future path of policy, forward guidance can impact current spending and investment decisions. And it was a particularly useful tool in a low-rate environment: when central banks are operating at the ‘zero lower bound’, they can’t cut rates further (barring an experiment with negative interest rates). They therefore need to seek out more innovative policy tools. Forward guidance can also inform markets that interest rates will stay low for longer than market pricing implies. This provides an additional economic stimulus and should, in theory, reduce both uncertainty and interest rate volatility. 

But today’s central banks are no longer operating at the zero lower bound. Rates are rising across many advanced economies amid an environment of consistently high (and surprising) inflation. Forward guidance loses its appeal in such an uncertain climate - and there is evidence that rate-setting committees are starting to abandon it. 

In June, the Fed increased rates by 75 basis points, having said in May that ‘a 75-basis-point increase is not something the committee is actively considering’. After the most recent rate-setting meeting, Fed chair Jerome Powell gave little indication of the future rate path, stressing that it was ‘a decision that will depend on the data we get between now and then’. The ECB also surprised in its July rate-setting meeting - raising rates by 50bps despite an unambiguous statement in June stating their intention to hike by 0.25bps. At the time of writing, the UK’s MPC had not yet met, but Governor Andrew Bailey had indicated that a 50bps rise was ‘on the table’. Another surprise is possible. 

Do central banks lose credibility by deviating from their earlier statements? Not necessarily.

The BoE’s Broadbent notes that market participants are prone to over-interpret forward guidance, especially where it is conditional. He argued in March that ‘the “if” clause is forgotten, or downplayed, and purely conditional statements somehow get interpreted (or rather misinterpreted) as hard commitments’. 

ING’s global head of macro, Carsten Brzeski, also argued that given soaring price the ECB cares less about predictability and more about its credibility as an inflation fighter. While a rate-setting committee could lose a little credibility by deviating from earlier announcements, they could lose even more by sticking to inappropriate policies just because they said they would. 

Will the end of forward guidance increase volatility? Firstly, research suggests that the impact of forward guidance is relatively short-lived. In a 2017 paper, the University of California’s Eric Swanson found that forward guidance had a statistically significant effect on medium-term US Treasury yields, stock prices and exchange rates. But these effects were largely transitory, with a half-life of just one to four months. 

ECB research indicates that weak forward guidance can even increase uncertainty. A 2019 paper by the ECB’s Michael Ehrmann and colleagues argued that forward guidance does reduce uncertainty in the short term, but also encourages market participants to overlook useful ‘private signals’. As a result, less information is dispersed and aggregated across the economy: it leads to less informative market prices and increased uncertainty overall. The BoE’s Broadbent concurs, arguing in March that ‘if you believe that the monetary authority will always tell you in advance what it’s going to do you may feel less inclined to anticipate and price such a response yourself’. 

If forward guidance withers away, market participants will be forced to rely on a wider range of signals to get a sense of where monetary policy might be heading. Expect an even greater focus on macroeconomic releases and forecasts: inflation, growth and unemployment figures will still be big news for some time yet.