Forward guidance is the term used by central banks to communicate what their future monetary policy will be. By using forward guidance, banks aim to calm uncertainty in markets and corporations. For example, if markets or company owners fear that low interest rates will move higher, interest rates on bonds and other credit instruments and agreements will rise and begin to discourage people and companies from taking out loans or spending money. If a central bank is able to transparently signal that it intends to keep rates low (if that is its intention), the market response will be appropriate to its overall policy.
Economists sometimes refer to two broad forms of forward guidance: Delphic and Odyssian. In the classic Delphic version of forward guidance the central bank states its economic outlook without any further commitment. This form of forward guidance tends to affect short term interest rates.
However, when the short term rate has a natural floor at zero, or is at the “zero lower bound”, a stronger signal is needed from central banks if they want to stimulate their economies. Odyssian forward guidance at the zero bound involves trying to convince markets that once the economy eventually recovers you won’t move interest rates straight away and will instead wait for longer before responding to rising inflation and growth. This raises the disposable income of borrowers encouraging more activity in the economy.
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In July 2013 the Bank of England and the European Central Bank decided to act to rein in the recent rise in market interest rates and tied any future rise in interest rates to economic and financial conditions. , faced dissent from within the Monetary Policy Committee (MPC) when he announced his forward guidance policy – his big idea to improve the UK economy.
In August 2013, the governor of the Bank of England, Mark Carney, decided to be more explicit about forward guidance stating in what was said to be one of the most substantial changes to the UK’s monetary policy framework since the rate-setting Monetary Policy Committee became independent in 1997. He indicated that he would look at raising rates should unemployment fall to below 7 per cent.
A few days later, Mark Carney signalled the end of his forward guidance of linking interest rates to the unemployment rate, adding that the British economy was in a different place to where it had been in the previous summer.