DEFINITION of 'Forward Guidance'

Forward guidance is verbal assurance from a country’s central bank to the public about its intended monetary policy. Forward guidance attempts to influence the financial decisions of households, businesses and investors by letting them know what to expect from interest rates (to the extent that the central bank can influence those 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 in the United States. Other central banks, such as the Bank of England, the European Central Bank and the Bank of Japan, use it as well.

BREAKING DOWN 'Forward Guidance'

In the United States, the Federal Reserve’s Federal Open Market Committee has used forward guidance as one of its major tools since the Great Recession. Through the use of forward guidance, the FOMC intends to help interest rates remain low to improve credit availability and stimulate the economy.

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, the FOMC in late 2013 and early 2014 said that 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 Federal Reserve policy. Janet Yellen, sworn in as Fed Chair in 2014, is a strong proponent 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, and financial markets may be more likely to function smoothly. For example, if the FOMC indicates that it expects to raise the federal funds rate in six months, potential homebuyers might want to get mortgages ahead of a potential increase in mortgage rates.

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