What is forward guidance?

Since 1997, the Bank of England’s Monetary Policy Committee has set a Bank Rate for the month ahead at its regular meetings. The US Federal Reserve and the Bank of Canada have for a while been saying what they intend their interest rates to be in the future but the Bank of England traditionally never set out its’ long term plans. However the new Bank of England Governor (Mark Carney) has been a pioneer of the approach to monetary policy, which is known as ‘forward guidance’.

Forward guidance simply involves a central bank saying what it intends to do in future about its main interest rate or other aspects of monetary policy like quantitative easing (QE).  Guidance could be time-dependent, where the bank announces that it will keep interest rates unchanged until a specified date.  It could be condition-dependent, with the bank saying it will keep policy unchanged until certain conditions are met (e.g. unemployment falls to a specified level).

How people and firms expect interest rates to move over the coming months and years is crucial in determining what they decide to do about spending and saving.  Forward guidance can be used to affect what people expect. For example, if people expect interest rates to remain low, they may commit to household spending which they would not otherwise consider if they thought that interest rates were about to rise. The Bank hopes that by setting out their long term plans, this will give people more confidence both in their personal and business lives.

The aim of the ‘plan’ is to boost spending and aid the economic recovery but for the Bank to retain its credibility it needs to deliver on its promises and to be clear on the key issues that may change how the economy runs.

Many believe that forward guidance will replace QE; rather than buying government bonds of different maturities to push down longer-term rates, the Bank can commit to a Bank Rate level for a period of time and market rates will adjust to it. 

The US is the best example where the Fed has used forward guidance with growing boldness.  From December 2008 through to 2011, it used phrases such as “for some time” to indicate how long it saw rates remaining low.  In August 2011, it upped the ante by putting a specific date against low rates (“at least through mid-2013”).  Then in December 2012, it went further by attaching specific conditions against the period for low rates, announcing that they would remain low as long as unemployment remains above 6.5% and inflation expectations remained contained.

And this isn’t the only way in which the Fed is using forward guidance.  It has also attached conditional guidance to its quantitative easing programme.  Late last year the Fed announced that it would undertake 85bn of QE per month until the labour market improves substantially.  Recent statements suggest the Fed will maintain its QE programme through to next year until unemployment falls from the current 7.6% to 7%.

For households this could mean lower borrowing rates or at least borrowing rates that remain lot giving people confidence to make larger purchases for items such as houses, cars etc.

For businesses more certainty engenders confidence to invest in the business thus increasing potential for expansion, including expansion of the workforce.

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