What is forward guidance in monetary policy?

Forward guidance is the use of communication by the central bank about its future actions to influence behavior of economic agents today. The logic of forward guidance is that central banks can influence monetary conditions today by giving indications about how they behave tomorrow.

Economic agents like investors frame their present investment and business policies today based upon their anticipation about the future. These economic agents always keenly observe the actions as well as the plan of actions of the central bank while making their business decisions. Hence central bank by giving a signal about the future monetary policy can definitely influence their actions today.

For central banks, forward guidance is now emerged as a powerful way to influence the actions of business people and investors in the various segments of the economy. An important nature of forward guidance is that central banks will be making a promise about its future interest rate actions.

Forward guidance got the limelight after the 2007 crisis. During the crisis time, the most powerful tool of the central bank- the short term interest rate (repo rate in India) was very low in the US and Europe. This means that central banks can’t give stimulus to the economy by bringing down interest rate further. Hence they searched for alternative tools. They assured low interest rate in the future by making policy commitments. This was the origin of forward guidance.