Forward guidance is communication by a central bank about where its policy settings are likely to go in the future. Instead of only announcing today's decision, the bank tells households, firms and markets what it expects to do with its policy interest rate, or with asset purchases, over the coming months or years, and under what conditions. The purpose is to influence expectations, because borrowing costs across the economy depend on the expected path of short-term rates and not just on their current level.
It is one of the main tools of modern monetary policy and works through the expectations channel of the monetary transmission mechanism. It became prominent after the 2008 financial crisis, when policy rates in many advanced economies were cut close to zero and central banks looked for other ways to ease financial conditions. It was used alongside quantitative easing and has remained part of the toolkit of the Federal Reserve, the European Central Bank and others.
How forward guidance works
Long-term interest rates reflect, in large part, the average short-term rate that investors expect over the life of a loan or bond, plus a term premium. If a central bank convinces markets that the policy rate will stay low for longer than they had assumed, expected future short rates fall, which lowers bond yields, mortgage rates and corporate borrowing costs today. The yield curve moves without any change in the current policy rate. Guidance can work in the other direction as well: signalling that rates will rise sooner or stay high for longer tightens conditions.
The effect depends on credibility. Markets must believe that the central bank will act as it says, and the public must understand the message. For that reason guidance is usually set out in the policy statement, repeated in press conferences and speeches, and supported by published forecasts.
Types of forward guidance
Economists and central banks distinguish several forms.
- Open-ended guidance. The bank gives a qualitative signal, such as saying that rates will stay low "for an extended period", without a date or condition.
- Calendar-based guidance. The bank names a time horizon, for example that rates are expected to remain at their current level at least until a stated date.
- State-contingent guidance. The bank ties its future action to economic outcomes, such as an unemployment rate or an inflation rate, so that the guidance adjusts automatically as data change.
- Published rate paths. Some central banks publish their own projection of the policy rate, or the individual projections of committee members.
A further distinction is made between guidance that is a forecast of what the bank will probably do, sometimes called Delphic, and guidance that is a commitment to a future course, sometimes called Odyssean. Most central banks stress that their guidance is conditional on the outlook and is not a promise.
History
Central banks gave hints about future policy long before the term was used, and a few inflation-targeting central banks began publishing interest rate paths in the 1990s and 2000s. The Bank of Canada gave an explicit conditional commitment in April 2009 to hold its rate until mid-2010. The Federal Reserve said in December 2008 that low rates were likely to be warranted "for some time", moved to calendar dates in August 2011, and in December 2012 adopted thresholds: rates would stay near zero at least as long as unemployment was above 6.5 per cent, provided projected inflation stayed no more than half a point above the 2 per cent goal.
The European Central Bank adopted forward guidance for the first time in July 2013, and the Bank of England followed in August 2013 with a threshold linked to an unemployment rate of 7 per cent. During the pandemic, guidance was again used to signal that rates would stay low until inflation and employment goals were met. When inflation rose sharply in 2021 and 2022, several central banks stepped back from detailed guidance and described their decisions as being taken meeting by meeting, depending on incoming data.
Criticism and limits
Forward guidance has well-known weaknesses. Conditional statements are often read by the public as promises, so a change of course can damage credibility; the Bank of England's 2013 threshold was reached much sooner than expected and the guidance had to be reworked within months. Guidance that is too firm can hold a central bank to a path that later proves wrong, and some critics argue that commitments made during the pandemic contributed to a slow response to the rise in inflation that followed, a point several central banks have acknowledged in reviews.
There is also a time-consistency problem: a promise to keep rates low after the economy has recovered is one the bank will later have an incentive to break, and markets know this. Economic models have tended to predict much larger effects from guidance than have been observed, a gap known as the forward guidance puzzle. Finally, guidance about negative rates, yield curve control or the pace of quantitative tightening adds complexity that can make the overall message harder to read.