The Future of Forward Guidance

It is also more difficult to believably communicate plans for the future the further away that future is. A lot can change in a year or two, which might lead the public to be rightly skeptical of the Fed's ability to predict its actions that far in advance. Jeffrey Campbell of the University of Notre Dame and Filippo Ferroni, Jonas Fisher, and Leonardo Melosi of the Chicago Fed allowed for such skepticism in their model of forward guidance. In a 2019 article in the Journal of Monetary Economics, they found that the Fed's ability to influence market expectations diminishes the further into the future it tries to communicate a policy path.

"If the Fed were to say something about rates one to four quarters in the future, agents in our model believe the Fed will follow through with that guidance," says Melosi. "At horizons longer than one year, it is much harder for the Fed to commit to future actions, arguably because macroeconomic uncertainty is typically large at those horizons."

Communication Costs

Empirical evidence supports the idea that forward guidance is effective. In a 2021 paper in the Journal of Monetary Economics, Eric Swanson of the University of California, Irvine examined FOMC announcements from July 1991 to June 2019 to identify the separate effects from changes to the federal funds rate, forward guidance, and QE. He found each tool had significant and distinct effects on financial markets. Forward guidance had the largest impact on shorter-term Treasury yields and assets — those dated between one and five years — while QE was more effective at moving longer-term Treasuries and corporate bonds with 10-year maturities.

"When you look at the reaction to FOMC announcements, most of the movement in Treasury markets is due to what the FOMC statement says, what the chair says during the press conference after the announcements, or what the chair says in speeches throughout the year, rather than the actual change in the federal funds rate," says Swanson. "In that sense, forward guidance has been very important over the last 20 years."

Although his findings focus on financial markets, Swanson suspects that forward guidance also had an impact on macroeconomic variables like unemployment. It is just harder to measure those interactions. Overall, the evidence supports Bernanke's claim that forward guidance is a potent tool.

But that doesn't mean there aren't costs. As Barkin noted, more explicit guidance imposes a greater constraint on the Fed's flexibility. While it is true that the Fed's guidance has never made an absolute commitment — the FOMC has always left room to deviate from its guidance if circumstances change — it has sought to live up to its guidance in practice, says Swanson. Indeed, it has never used those escape clauses; it has postponed tightening for longer than it previously indicated but not tightened sooner.

In a 2019 working paper, Taisuke Nakata of the University of Tokyo and Takeki Sunakawa of Hitotsubashi University showed that the reputational cost of breaking previous forward guidance can itself act as a form of commitment. If a central bank were to renege on its previous forward guidance, that would erode its credibility, and future attempts to use forward guidance would be less effective because the public would not trust the central bank to keep its word. To the extent that the Fed wants to avoid that outcome, its forward guidance is binding, even if the option to break it still exists. Sticking with previous guidance to preserve credibility could delay the Fed's response to unexpected economic developments. Indeed, some have argued this was the case during the recent uptick in inflation.

"In 2020 and 2021, the Fed was very explicit that it didn't want to raise the fed funds rate for some time," says Swanson. "Looking back, it now seems like they were too slow in raising interest rates. Probably part of the reason they were too slow was that they wanted to follow through with the guidance they had given."

There is also some evidence that too much talking by the central bank could drown out other valuable market signals. A 2019 paper in the Journal of Monetary Economics by Gaetano Gaballo of HEC Paris and Michael Ehrmann, Peter Hoffmann, and Georg Strasser of the ECB studied the use of forward guidance in different countries. They discovered that when central banks provide calendar-based guidance over a short time horizon, it can paradoxically raise the sensitivity of government bond prices to surprising economic news. This is because market participants pay too close attention to central bank communications, weakening normal market price signals and leading to larger shocks when unexpected news hits.

Choosing the Right Tool

In an Oct. 12 speech, Fed Governor Michelle Bowman spoke about the trade-off between specificity and flexibility when using forward guidance. Less detailed guidance could allow the Fed to be nimbler in the face of unexpected developments, but it might also mean that the Fed's communications are less clear and effective. In contrast, more precise language might be more effective at aligning market expectations but could limit the Fed's ability to quickly adjust its policy path.

In the end, Bowman argued, the Fed must weigh the costs and benefits of using forward guidance in each economic environment. In the aftermath of the 2008 financial crisis, she said, the benefits of using forward guidance were clear. The Fed couldn't reduce its main policy rate any further, and it seemed a safe bet that the fed funds rate would remain low for some time. Communicating an intention to keep its policy rate lower for longer in this environment "was not seen as posing significant risks to the Committee's credibility," she said.

In contrast, the current economic environment poses a very different challenge for the Fed. It must balance between tightening too much in response to inflation and not tightening enough. That makes it harder for the FOMC to know the appropriate size and duration of policy moves in advance. Additionally, the Fed's primary policy tool is no longer constrained by the zero lower bound now that it is raising rates, making the Fed less dependent on tools like forward guidance to achieve its policy goals.

"Putting it all together … the case for explicit forward guidance is much less compelling today than it was in the years that immediately followed the 2008 financial crisis," said Bowman. "My own view is that discussions about the use of explicit forward guidance as a policy tool should be limited. It should be used during periods when the Committee cannot adjust the federal funds rate any lower due to the effective lower bound, and when the Committee also has reasonable confidence that the federal funds rate will need to remain near zero for a period of time to stimulate growth and when inflationary pressures are expected to be subdued."

Neither Bowman nor any of her FOMC colleagues have advocated for significantly scaling back the overall increase in transparency that the Fed has made in recent decades. Such moves are widely viewed as beneficial by economists and policymakers alike. Indeed, while the Fed seems to be stepping back from what Bowman calls explicit forward guidance, it is still providing some general guidance about its plans.

During his address at the annual Jackson Hole Economic Symposium in August, Powell noted that "restoring price stability will likely require maintaining a restrictive policy stance for some time." And in November, the FOMC said that the pace of its future policy rate increases would "take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments."

To the extent that such statements qualify as forward guidance, then reports of the tool's demise were premature. Instead of phasing out forward guidance altogether, it seems likely that the Fed may need to periodically adjust how it communicates with the public to best meet the economic challenges of the day.

READINGS

Bowman, Michelle W. "Forward Guidance as a Monetary Policy Tool: Considerations for the Current Economic Environment." Speech at the Money Marketeers of New York University, Oct. 12, 2022.

Campbell, Jeffrey R., Filippo Ferroni, Jonas D.M. Fisher, and Leonardo Melosi. "The Limits of Forward Guidance." Journal of Monetary Economics, December 2019, vol. 108, pp. 118-134. (Article available with subscription; previous working paper version available.)

Ehrmann, Michael, Gaetano Gaballo, Peter Hoffmann, and Georg Strasser. "Can More Public Information Raise Uncertainty? The International Evidence on Forward Guidance." Journal of Monetary Economics, December 2019, vol. 108, pp. 93-112. (Article available with subscription; previous working paper version available.)

Swanson, Eric T. "Measuring the Effects of Federal Reserve Forward Guidance and Asset Purchases on Financial Markets." Journal of Monetary Economics, March 2021, vol. 118, pp. 32-53. (Article available with subscription.)