In December 2012, the Federal Open Market Committee— these are the people who determine U.S. monetary policy — announced it would employ a 2.5% inflation rate threshold and 6.5% unemployment rate threshold to guide monetary policy. This so-called forward guidance is part of the Fed's ongoing efforts to be more transparent.
With the unemployment rate tumbling even as many other labor market stats remain weak, economists expect the Fed to make some changes to that forward guidance during this week's FOMC. For example, they may do away with that 6.5% threshold.
But does this mean the Fed is full of crap and their words mean nothing?
Of course not. That 6.5% threshold was never set in stone as a trigger for interest rate hikes. To appreciate this, you need to understand the nuances of the language coming from the Fed.
Columbia Management's Zach Pandl offers a brief primer on forward guidance and how it shapes Fed credibility.
The styles of forward guidance provided by central banks differ along two main dimensions: (1) the degree of commitment and (2) the motivation for providing guidance in the first place. Both aspects can affect credibility, and therefore the importance of these statements for markets.
Forward guidance can take the form of an explicit commitment or a forecast. Central banks never make unconditional promises (at least about instruments), so there is not a black and white difference here. But in general, commitments are more difficult to reverse, either because policymakers’ credibility is on the line or because of institutional details of the policy framework. Statements that contain explicit commitments are more credible and should be taken more seriously by investors. Forward guidance based on forecasts alone (“we think we will raise rates next year because we forecast that inflation will rise”) is easier to reverse, less credible and should be given less weight by investors (even if it conveys some relevant information).
The motivation for forward guidance also differs over time and across countries. The distinction comes down to whether guidance intends to clarify the existing policy approach or signals an intentional deviation from historical policy. In other words, whether it simply restates the reaction function or changes the reaction function. The European Central Bank, for instance, is adamant about the fact that its “extended period” guidance is only meant to clarify its existing approach. In contrast, many academic economists argue that policymakers should use forward guidance to intentionally deviate from past behavior in order to provide additional monetary stimulus at the zero lower bound—i.e. to go “lower for longer.” In our view, forward guidance that clarifies an existing framework is more credible, because the central bank will be less likely to change its mind in the future. Forward guidance which intends to deviate from past behavior should be considered less credible, because we cannot be sure that the central bank in the future will actually follow through with the plans laid out in the past (especially when the composition of the policy committee changes over time).
Pandl offers this table summing up his thoughts.
"The most credible type of forward guidance is one that clarifies the existing policy approach and backs up statements with some type of commitment," he said. "The weakest type of forward guidance is a forecast that the central bank will behave in the future differently than it has behaved in the past."
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