In this review, the Bank of Israel Research Department examines various aspects of forward guidance, a tool that has become more common among central banks in recent years. The aim of the survey below is to present the Forward Guidance instrument, the issues raised by its use, and the experience accumulated around the world.
- In recent years, the monetary interest rate in many countries has reached near zero. In order to continue encouraging economic activity, various central banks have begun using unconventional monetary policy tools, among them forward guidance, whereby the central bank announces its future policy path.
- Forward guidance can encourage economic activity when the interest rate tool is close to being exhausted, but experience accumulated around the world shows that its use is complex. This complexity can be seen in large economies such as the US and Europe, but is particularly significant in small and open economies, since economic activity in such economies is to a large extent connected to global developments which the central bank cannot influence.
Forward guidance: objectives and challenges
The financial crisis of 2008 led central banks throughout the world to adopt more accommodative monetary policies, in particular by reducing the short-term interest rates. However, the hoped-for recovery was late in coming, and the central banks were required to lower the interest rate further. As a result, the interest rates in many countries have, in recent years, reached near zero, and in some have reached zero. In such a situation, the central bank’s ability to reduce interest rates further is limited, and furthermore, there are doubts regarding the efficacy of such a measure. Therefore, many central banks have used unconventional monetary tools alongside low interest rates to continue encouraging economic activity. These tools are not used by central banks during routine times, because they are less able to support the objectives of the banks than the monetary interest rate, or because they involve higher costs. However, when the routine monetary tool—the monetary interest rate—is nearly exhausted, the need arises to assess additional tools for encouraging activity.
One unconventional tool—the use of which has expanded in recent years—is forward guidance. Among the countries that have used this tool are the US, the UK, Canada, and Sweden, as well as the European Central Bank. To understand the mechanism of this unconventional instrument, it is worth discussing the conventional monetary instrument available to the central bank—the monetary interest rate. The monetary interest rate influences the yields on the public’s short-term financial assets. When the central bank sets the monetary interest rate, it influences market short-term interest rates, and through them, economic activity. When the monetary interest rate reaches near-zero levels and cannot be further lowered, actions to reduce long-term interest rates may serve as an alternative tool to encourage activity in the economy.
The long-term interest rates are set, inter alia, based on the expected short-term interest rate in the future. To illustrate, if commercial banks expect that the monetary interest rate will remain low over time, and they can take low-interest loans from the central bank, they will be prepared to offer the public loans for longer periods at low interest rates. Such loans, in turn, may contribute to encouraging activity in the economy. In accordance with this logic, forward guidance focuses mainly on an attempt to create expectations among the public that the monetary interest rate will remain low for an extended period, longer than what the public had initially expected, with the idea that this will lead to a decline in the long-term interest rates and to encouragement of activity in the economy.
The most important factor in the success of guidance is credibility. Since guidance is intended to affect expectations, it will be effective only if the central bank’s commitment is credible in the eyes of the public. In other words, the extent of this policy tool’s influence is dependent on the public’s ability to believe that the central bank will adhere to the policy that it declares. However, a commitment to a future policy path may make it difficult for the central bank, since it impairs the bank’s flexibility and ability to respond to unexpected scenarios in the economy: the ability to deal with short-term shocks is essential to meeting the central bank’s stability targets, and anything that restricts it from this standpoint makes it difficult for it to do its work. Since the public understands this, it may place in doubt the credibility of the commitment made by the central bank, and in such a situation, guidance will have a reduced effect on expectations.
Credibility is inherently connected to the clarity of the message published by the central bank. A commitment to a clear and transparent policy contributes to credibility since it enables the public to critique the extent to which the central bank meets its commitments. Yet at the same time, such a commitment may lower credibility, since it restricts the central bank to a greater extent, and the public may think that the central bank cannot maintain, over time, the policy to which it has committed. As such, the success of the guidance is dependent on finding the balance between providing a clear message and maintaining the central bank’s flexibility.
Another important consideration in the decision regarding the measure of clarity of the message is how the message may be received by the public. Clarity is essential so that the message is not mistakenly interpreted by the public. For instance, if the central bank declares that the interest rate will remain low for an extended period of time, the public may interpret it as an expectation on the part of the bank that throughout that period, the economy will be in recession, and low interest rates will be needed to support the economy. This may be true even though the central bank assessment is that basic forces for such a recession do not exist. Therefore, the central bank must clarify that it is maintaining low rates to compensate for the period when the lower bound prevented it from setting rates sufficiently low at that time and not because of current conditions.
The complexity involved in the need for a balance between providing clarity and transparency in the central bank’s message and maintaining the bank’s flexibility is reflected in the developments in forward guidance in the US. One option in providing a clear commitment is making policy contingent on the developments of macroeconomic parameters. The parameters that serve to anchor the forward guidance must be reliable indicators of the state of the economy, and must also be measurable with great precision. Beginning in December 2012, the Federal Reserve (Fed) used the unemployment rate as an anchor for guidance, and conditioned monetary interest rate policy on it. The Fed’s Federal Open Market Committee announced that it would leave the interest rate at 0 percent to 0.25 percent for at least as long as the unemployment rate remained above 6.5 percent, inflation for one-to-two years ahead is projected to be no more than 2.5 percent, and longer-term inflation expectations “continue to be well anchored”. This commitment was conditioned on transparent and measurable parameters, but the Fed was noticeably cautious in defining policy in this manner, and maintained the option of leaving the interest rate at low levels even if the unemployment rate dropped below 6.5 percent, and even if inflation expectations exceeded 2.5 percent. In fact, at the end of 2013, when the unemployment rate approached the selected threshold but many other economic parameters indicated continued weakness in the economy in general and in the labor market in particular, the Fed chose to leave the interest rate at low levels. In March 2014, the Fed updated the language of its declaration and announced that the interest rate would remain in the range of 0 percent to 0.25 percent for a period that would be determined by weighting various labor market indicators, inflation pressures and inflation expectations. The new language of the announcement did not include specific parameters or threshold levels that would guide the interest rate decisions.
These developments illustrate the challenge inherent in conditional guidance: It must be simple and clear, but simultaneously must provide a good representation of the state of the economy. The US experience shows that it is difficult to balance these two objectives.
Forward guidance is, therefore, mainly intended to reduce long-term interest rates, but may also contribute to increasing stability in the markets. Market volatility and uncertainty, as characterizing the global economy in recent years, are accompanied by unexpected developments, which in turn impact on monetary policy. While during periods of economic stability the public is reasonably able to set monetary policy expectations based on the central bank’s previous response patterns, this becomes difficult during periods of volatility and uncertainty in economic variables. Policy measures may surprise the public and increase instability in the markets. The central bank’s commitment to a defined policy may reduce the uncertainty and make it possible for the public to plan its behavior according to an interest rate path that is known in advance.
Increasing certainty may also contribute to reducing the long-term interest rates. Long-term financial asset yields include a risk premium that compensates for uncertainty regarding future interest rates. When the central bank adopts measures that increase certainty in this area, it causes a reduction in the risk premium, thereby further assisting in reducing the interest rates. In other words, forward guidance may influence long-term interest rates both by influencing expected interest rates and by reducing the risk premium.
Stability was an important consideration when the European Central Bank (ECB) decided in July 2013 to begin using forward guidance. This decision was reached against the background of high volatility of yields in European markets, a phenomenon that increased following the ECB’s May 2013 decision to reduce the monetary interest rate to 0.5 percent. This volatility reflected the increasing sensitivity of expectations to financial factors that are not fundamentally connected to the European economy, and it impaired the effectiveness of the monetary interest rate reductions. Aiming to stabilize expectations and improve the pass-through mechanism between the monetary interest rate and market interest rates, the ECB decided to use forward guidance even though the interest rate tool was still not fully exhausted at the time.
The ECB’s declaration of its intention to stabilize the volatility in the markets during a period of uncertainty may be considered credible due to the relative size of the European market and the extent of its influence on global financial markets. In contrast, in smaller economies, an attempt to set policy during a period of uncertainty may be viewed as lacking credibility, since during such a period, the central bank’s flexibility is of particular importance.
The use of forward guidance around the world
The need to balance the many and complex elements of forward guidance has led various central banks to use this tool in a variety of ways, from soft guidance that presents a very general policy path to stronger guidance in which the central bank commits to a well-defined policy. The types of forward guidance that have thus far been used around the world can be divided into four main categories:
1. Forward guidance with no commitment to a time frame or to meeting defined targets
—a general declaration of intentions regarding the policy that the central bank intends to adopt in the future, without defining clear terms for its implementation. An example of this can be found in the notice published by the Fed in 2003, in which it said that the policy formulated at that time would continue for a considerable period.
2. Qualitative forward guidance conditioned on a narrative
—Outlining a path for economic policy with a qualitative character, contingent on a trend of development of macroeconomic parameters. An example of this can be found in the press release published by the ECB in July 2013, in which it states that the interest rates are expected to remain low for an extended period of time, “based on the overall subdued outlook for inflation” and the general weakness in markets.
3. Calendar-based forward guidance
—A commitment to a certain monetary policy for a defined period of time. For example, in April 2009, the Bank of Canada lowered its monetary interest rate to 0.25 percent and announced that “the target overnight rate can be expected to remain at its current level until the end of the second quarter of 2010”.
4. Quantitative-parameter based forward guidance
—Forward guidance of this type outlines monetary policy according to numerical values of measurable macroeconomic parameters. An example of this is the aforementioned commitment by the Fed to leave interest rates at 0–0.25 percent as long as the unemployment rate remains above 6.5 percent and inflation between one and two years ahead is projected to be no more than 2.5 percent.
The complexity inherent in forward guidance did not lead only to differences between countries in how this tool was used, but also to adjustments to guidance within countries. An example of this is in the conduct of the Fed, the first large central bank to use the forward guidance tool following the 2008 financial crisis. When the Fed used it for the first time after the outbreak of the crisis at the end of 2008
, it was the first type of forward guidance—a general declaration of intent on the part of the central bank. As confidence in the effectiveness of this tool increased, the Fed boosted the clarity of its commitments to the public, and over the years it tried all of the types of forward guidance described above. However, as noted, the Fed also gained experience in the complexity inherent in guidance that is anchored in the unemployment rate, and chose to return to vaguer guidance.
The ECB only began using forward guidance in July 2013, and chose to do so with tremendous caution. Thus far, the ECB has used qualitative forward guidance conditioned on a narrative, which does not impose too much commitment on the central bank. This caution is not surprising in view of the complexity of the eurozone’s economy, which is made up of several countries, with different characteristics. Due to the unique character of the eurozone’s economy, the ECB was forced to deal with a high number of uncertainty factors, and its actions do not always win uniform support from fiscal policy, which is set separately in each country. The uncertainty coming from many varied sources, and the central bank’s high level of dependence on factors that are not within its control, make it difficult for it to commit to an unambiguous policy.
Forward guidance in small and open economies
The main difficulty that forward guidance presents to a central bank is the difficulty in committing to a future policy in a manner that generates credibility. This difficulty is common to all central banks, and derives from the fact that monetary policy is dependent on factors that are outside the central bank’s control, forcing it to constantly deal with unexpected challenges and with new information. As noted, large economies—such as the US and Europe—also have constant uncertainty with which the central bank is forced to deal, and which makes it difficult to use forward guidance. Such uncertainty exists even more in small and open economies. Openness to trade and to capital flows exposes them to a very great extent to the impact of global economic events. From the point of view of the small economy, global developments are external to the domestic economy but have a marked influence on it. Therefore, in such economies the central bank may be able to influence a relatively small group of economic variables, and is faced with tremendous uncertainty.
In small and open economies, there is tremendous importance to capital flows and to the exchange rate. In a small economy that relies to a large extent on foreign trade, the exchange rate has considerable influence on the domestic economy, and therefore constitutes a main consideration when determining the monetary interest rate. Monetary policy impacts on the exchange rate, since it determines the differential between the domestic interest rate and global interest rates—when monetary policy is restrictive relative to policy abroad, it leads to a positive differential between domestic and overseas rate, and to appreciation of the domestic currency; a negative differential between the interest rates contributes to depreciation of the domestic currency. Forward guidance in a small economy may cause the central bank to commit to an interest rate path that is not in line with interest rates abroad. Such a commitment limits the central bank’s ability to deal with changes in the exchange rate by adjusting the domestic interest rate to developments in global interest rates, and may thereby expose the economy to foreign trade risks, and sometimes also to financial stability risks.
Even though the use of forward guidance is more complex in small economies, there are countries that have decided to use this tool, among them Sweden. The Riksbank (central bank of Sweden) began using forward guidance in April 2009, and in parallel with the reduction of the monetary interest rate to 0.5 percent, it announced that “the repo rate is expected to remain at a low level until the beginning of 2011”. As a result of this announcement, interest rate expectations were actually revised upwards, apparently because before the declaration, the public expected a significant interest rate reduction in the future, but it interpreted the notice by the central bank as a declaration that the interest rate would be kept at 0.5 percent for a year and a half. In July 2009, the Riksbank reduced the monetary interest rate to 0.25 percent, and declared that the repo rate “is expected to remain at this low level over the coming year”. This notice led to a downward revision of immediate-term expectations, but expectations for terms of close to one year were only slightly influenced by the declaration. It is possible that this moderate influence derived from the fact that the interest rate path published by the Riksbank was different from the path that the Fed published during the same period. This is consistent with the argument that global data influence expectations in a small and open economy, and when the central bank’s declaration is not in line with these data, it may have a smaller impact on expectations. In the following years, the Riksbank continued to use forward guidance. In October 2014, the Swedish central bank reduced the interest rate from 0.25 percent to 0 percent. In the press release, it was noted that even though real economic data were encouraging, inflation in Sweden remained low, which made it necessary to reduce the interest rate. It was also stated that the interest rate “needs to remain at this level until inflation clearly picks up. It is assessed as appropriate to slowly begin raising the repo rate in the middle of 2016”.
The Bank of Canada also gained experience in calendar-based forward guidance. Even though Canada’s economy is not considered small, it is influenced to a great extent by the American economy, and the issues facing the Bank of Canada are therefore similar to those facing the central bank of a small and open economy. As noted, the Bank of Canada reduced the monetary interest rate in April 2009, to a level of 0.25 percent, and in parallel announced that it would leave the interest rate at that level until the end of the second quarter of 2010. Toward the end of that period, the Bank of Canada announced that in view of the publication of encouraging data, “the need for such extraordinary policy is now passing, and it is appropriate to begin to lessen the degree of monetary stimulus”. And in fact, in June 2010, the Bank began to increase the interest rate, and in September 2010 it reached 1 percent. Since that experience, the Bank of Canada reduced its use of guidance and moved to vaguer policy declarations, and in October 2012, it stopped the use of this policy instrument altogether. An examination of the interest rate expectations derived from Canadian capital markets indicates that the Bank of Canada’s April 2009 declaration had a significant impact, reflected in the downward revision of expectations. However, a few weeks later, interest rate expectations increased, apparently as a result of the publication of encouraging data regarding the US market. This increase in expectations reflects the complexity inherent in forward guidance in an economy that is to a large extent influenced by economic developments in other economies.
As such, it seems that there is little experience with forward guidance in small and open economies, and it resulted in partial success. The main effect of forward guidance in these countries was reflected in very short-term interest rates, and it mostly wore off in a short time.
What all the experiences in the small economies had in common was that the policy paths committed to by the central bank did not relate to global influences. Such commitments, even if considered credible in the immediate term, lost their power over slightly longer terms, apparently due to uncertainty regarding the central bank’s ability to conduct monetary policy independent of global developments. The effect of the declaration was even weaker once new information about global developments considered relevant to the domestic economy was published. This information increased the concern that the central bank would be forced to deviate from its original commitment. Monetary policy’s dependence on global developments is an issue that is common to all economies, both small and large, but it is particularly significant in small economies since they rely to a greater extent on foreign trade.
It is likely that the problem can be solved through forward guidance that would include reference to interest rate differentials vis-à-vis the large economies or the exchange rate, in addition to reference to domestic parameters. Thus far, no attempt has been made to use this type of guidance. However, it may be relevant in view of the issues raised by forward guidance in small and open economies, and particularly in view of the need of such countries to deal with changes in the exchange rate and with interest rate differentials vis-à-vis the large economies. A commitment that also refers to interest rates abroad or to the exchange rate could help the central bank deal with the risks concerning foreign trade, a component that, as stated, is of particular significance in small and open economies. Furthermore, such a commitment may be considered by the public to be more credible, since it indicates that the central bank is cognizant of its dependence on the global economy.
The types of forward guidance used around the world are mainly intended to reduce longer-term interest rates. Guidance that is contingent on an interest rate differential or on the exchange rate has a slightly different character, and may impact activity mainly via the exchange rate channel. As noted, in small and open economies, the exchange rate has a large effect on the domestic economy, and guidance that operates via this channel may therefore be effective in encouraging activity. To illustrate, if the central bank announces that the domestic interest rate will be lower than the worldwide interest rate for a marked period, its announcement may weaken the domestic currency in the present. This depreciation may spur exports, and thus economic activity and inflation.
Most of the advanced economies have been characterized since the global crisis by a low interest rate environment, which has led to the expanded use of unconventional monetary tools, including forward guidance. Forward guidance makes it possible for a central bank to continue encouraging activity in the economy even when the conventional policy tool—setting the interest rate—is exhausted. However, it seems that the forward guidance instrument, similar to other unconventional monetary tools, is not free of problems. This may explain why it was used only sparingly before the recent global crisis, and why central banks that chose to use it did so cautiously. The complexity inherent in the use of guidance can be seen in both large economies and small economies, but is particularly significant in small and open economies because they are based to a large extent on foreign trade. It is possible that the difficulty that is unique to small and open economies can be solved through forward guidance that includes reference to global interest rates or to exchange rates, in addition referring to domestic parameters. Though forward guidance of this type has not been attempted so far, it seems that there is room to try it since it may contribute to the success of the use of this policy tool.
It is common practice to consider zero as the monetary interest rate’s lower bound, due to the concern that the public will move to cash at the expense of deposits in banks. However, from a technical standpoint, there is nothing to prevent a negative interest rate.
More discussion on unconventional monetary tools used since the recent global crisis can be found in “Unconventional monetary policy: goals and means”, in Monetary Policy Report 40, January 2014, pp 25–30 (Bank of Israel).
A discussion of this change in forward guidance by the Fed can be found in the speech by Fed Chair Janet Yellen in August 2014: Yellen, Janet (2014), “Opening Remarks”, Labor Market Dynamics and Monetary Policy: 2014, Jackson Hole Symposium, Federal Reserve Bank of Kansas City.
More on the guidance policy adopted by the ECB and the considerations guiding its use of this instrument can be found in: ECB (2014), “The ECB’s Forward Guidance”, ECB Monthly Bulletin, April 2014, pp. 65–73.
See, for example, the December 2003 press release from the FOMC: http://www.federalreserve.gov/boarddocs/press/monetary/2003/20031209/default.htm
The press release published by the ECB can be found at: http://www.ecb.europa.eu/press/pressconf/2013/html/is130704.en.html
The relevant notice published by the Bank of Canada can be found at: http://www.bankofcanada.ca/2009/04/fad-press-release-2009-04-21
The literature sometimes refers to another type of forward guidance—a staff forecast, which refers to publishing a conditional projection by the central bank regarding the monetary interest rate. However, the staff forecast does not obligate the central bank in any way, and since this survey views guidance as a clear declaration of intent by the central bank regarding future interest rates, it does not refer to the staff forecast.
The Fed used guidance before the crisis as well.
A broad survey regarding forward guidance in small and open economies can be found in: Misgav, Alon (2014), “Forward Guidance in Small, Open Economies”, BA Seminar Paper, PPE, Faculty of Social Sciences, Hebrew University of Jerusalem, Advisor: Dr. Edward (Akiva) Offenbacher (unpublished).
A survey of studies regarding the influence of forward guidance on expectations in Sweden and Canada can be found in: Woodford, Michael (2012), “Methods of Policy Accommodation at the Interest-Rate Lower Bound”, from the 2012 Jackson Hole Symposium: The Changing Policy Landscape, Federal Reserve Bank of Kansas City. It is worth noting that it is difficult to estimate how one-time events—such as a surprise announcement from the central bank—affect expectations. First, the estimation of expectations is complex, and the indices used for this purpose are generally accompanied by noise. Second, expectations are influenced by many factors, and the more the date of the central bank’s announcement recedes, the harder it is to isolate the effect of the announcement on expectations.