Forward Guidance: What it is, How it Works, Examples

What Is Forward Guidance?

Forward guidance refers to the communication from a central bank about the state of the economy and the likely future course of monetary policy. It is the verbal assurance from a country's central bank to the public about its intended monetary policy.

Understanding Forward Guidance

Forward guidance attempts to influence the financial decisions of households, businesses, and investors by providing a guidepost for the expected path of interest rates. The central bank's clear messages to the public are one tool for preventing surprises that might disrupt the markets and cause significant fluctuations in asset prices.

Forward guidance is a key tool of the Federal Reserve (Fed) in the United States. Other central banks, such as the Bank of England (BOE), the European Central Bank (ECB), and the Bank of Japan (BOJ), use it as well.

How Forward Guidance Works

Forward guidance consists of telling the public not only what the central bank intends to do but what conditions will cause it to stay the course and what conditions will cause it to change its approach.

For example, in early 2014, the Fed's Federal Open Market Committee (FOMC) said it would continue to keep the federal funds rate at the lower bound at least until the unemployment rate fell to 6.5% and inflation increased to 2% annually. It also said that reaching these conditions would not automatically lead to an adjustment in Fed policy.

Benefits of Forward Guidance

With some sense of where the economy might be headed, individuals, businesses, and investors can have greater confidence in their spending and investing decisions. Also, forward guidance can help the financial markets function more smoothly. For example, if the FOMC indicates it expects to raise the federal funds rate in six months, potential home buyers might want to get mortgages ahead of a potential increase in mortgage rates.

Example of Forward Guidance

In the U.S., the Fed's FOMC has used forward guidance as one of its major tools since the Great Recession.

Through the use of forward guidance, the FOMC has communicated its intent to keep interest rates low for as long as needed to improve credit availability and stimulate the economy. Similarly, Fed Chair Jerome Powell communicated to the financial markets that the Fed would continue to support the U.S. economy until the effects of the global financial crisis have subsided.