Forward guidance is a tool used by central banks to share information about their future monetary policy plans with the public. They use forward guidance to achieve economic objectives and prepare financial markets and individuals for policy changes.
Central banks express forward guidance through statements. If their statements are to be believed, people react accordingly. In a sense, they get a reaction without explicitly having to do anything.
How do central banks use forward guidance?
Forward guidance comes in different forms. We can break them down into three categories:
Qualitative forward guidance
This is exclusively made up of words. A central bank might say, ‘we plan to keep interest rates low for an extended period of time’.
Quantitative forward guidance
This involves a central bank including some form of numerical figure in its guidance. For example, it could be phrased as, ‘we plan to stop our quantitative easing (QE) programme by the end of 2022’. This gives banks, businesses, markets and individuals a clear deadline to work towards.
Conditional forward guidance
This type of forward guidance can be ambiguous. Central banks may say, ‘we will increase interest rates once economic growth recovers’. With no clear indication, markets must devise their own idea of what satisfactory economic growth looks like.
They will react to signs that hint at growth. For example, strong US nonfarm payrolls data may boost the value of the dollar if the Federal Reserve (Fed) had made a similar statement.
Alternatively, a central bank could be more specific with its conditions. For instance, it could say ‘interest rates will stay low until unemployment falls to 6.5% and inflation increases to 2% annually’. This is similar to some real conditional forward guidance given by the Fed in 2014.
Example of forward guidance in monetary policy
Let’s say a central bank has made changes to its monetary policy. It’s dropped interest rates down to zero and started a QE programme. The bank might do this to help economic recovery after a pandemic or a black swan event.
Reducing interest rates accelerates economic growth as people spend their savings and get cheaper loans. To ensure loans stay cheap for the public, the central bank might use forward guidance to goad commercial banks into keeping their rates down.
The central bank may announce it will keep interest rates at zero percent for the foreseeable future. If commercial banks believe the central bank, they will set their prices accordingly.
The result is cheap loans and mortgages from commercial banks to the public, encouraging consumer spending and boosting economic growth. Mission accomplished for the central bank.
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Why do central banks use forward guidance?
The above example shows how a central bank might use forward guidance to achieve an economic objective. And, like we mentioned earlier, central banks also use forward guidance to prepare financial markets for changes in monetary policy.
These changes could be a rise or fall in interest rates or the beginning or end of a QE programme.
They do this to prevent disruption in financial markets. A sudden shift in monetary policy could cause serious fluctuations in the price of stocks, bonds and currencies.
The Bank of England (BoE), for instance, may announce an interest rate hike in the United Kingdom will be coming in two-months’ time. This would allow the foreign exchange (FX) market to value the pound accordingly, keeping a lid on FX volatility.
The Federal Reserve and forward guidance
The Fed was the first major central bank to introduce a forward guidance policy. It began using forward guidance in its post-meeting statements in the early 2000s.
In June 2004, the Federal Open Market Committee (FOMC) gradually warned that a tightening of monetary policy was coming. It altered the language in its post-meeting statements to prepare the public for an eventual hike in interest rates.
After the financial crisis in 2008, the FOMC dropped interest rates to near zero. It used conditional forward guidance, stating that interest rates will stay low until the economy recovers.
The Bank of England and forward guidance
The BoE launched its forward guidance policy in August 2013. Mark Carney had just taken the reins as the bank’s new governor and was committed to being more transparent with the public.
The main shift was to be open about unemployment figures and use them to suggest whether macroeconomic policy was working. Depending on these figures, monetary policy could have been tightened or loosened during Mark Carney’s tenure.
The BoE hoped its forward guidance would reduce the risk of market interest rates rising prematurely and scaring the public about early rises in borrowing costs.
The European Central Bank and forward guidance
Similarly to the BoE, the European Central Bank (ECB) introduced forward guidance in 2013. Following a Governing Council meeting in July, the ECB released a statement regarding inflation and monetary policy.
The statement read, ‘the Governing Council expects the key ECB interest rates to remain at present or lower levels for an extended period of time.
This expectation is based on the overall subdued outlook for inflation extending into the medium term, given the broad-based weakness in the real economy and subdued monetary dynamics.’
The key aspect of forward guidance being ‘extended period of time’. This was the first occasion the ECB used forward guidance.
Real world example of forward guidance
As we mentioned earlier, forward guidance only works if people believe a central bank. When the Fed uses forward guidance, people tend to believe it and act accordingly. This is because the Fed is credible and has a reliable history of following through with its forward guidance. However, this isn’t the same for all central banks.
In 2015, the Swiss National Bank (SNB) lost considerable credibility after failing to prepare markets for a dramatic change in policy.
Four years earlier, the SNB had placed a price cap on the value of the Swiss franc (CHF), pegging it against the euro at 1.20. The euro was going through a crisis and the franc became a popular safe haven choice among investors. As demand ramped up for the Swiss currency, so did its price.
The SNB was forced to introduce the cap to prevent the franc’s soaring value from damaging demand for Swiss exports. Forward guidance was given that the CHF/EUR peg would remain in place.
However, just a few weeks later, the SNB abandoned the price cap overnight without warning. The decision caused the franc to massively appreciate and rocked markets across the globe. USD/CHF dropped by 17.69% and EUR/CHF fell by over 2,000 pips from 1.2011 to 0.9752 on 15th January 2015.
This caused many FX traders and brokers to go bankrupt and damaged the SNB’s credibility. Markets became apprehensive about the SNB’s forward guidance in the years that followed. In many ways, the SNB lost its ability to successfully use forward guidance as a tool.
Protect against market uncertainty
Forward guidance from central banks is a crucial factor affecting the value of currencies. Sometimes, like in our example above, central banks abandon their forward guidance, causing serious FX risk.
Although these changes may come out of the blue, there are ways you can limit the impact of resulting currency movements.
With Privalgo’s state-of-the-art financial solutions, you can protect your businesses from market fluctuations and capture maximum value on your international transfers.
We’ll allocate you a dedicated Foreign Exchange Specialist who’ll get to know you and your business. They’ll walk you through every step of the process and create bespoke strategies to meet your FX requirements.
If you’d like to hear how a Privalgo Foreign Exchange Specialist can help your business, request a callback.