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Understanding ECB forward guidance

ECB forward (policy rate) guidance has the declared intent to communicate the Governing Council’s reaction function and its assessment of the economy. It is not an unconditional pre-commitment and does not intend to generate above-target inflation. At the present juncture, forward guidance includes an easing bias.

Forward guidance and the ECB, Peter Praet, 6 August 2013

The below are excerpts from Mr. Praet’s column. Emphases have been added

“The Introductory Statement to the Press Conference following the ECB’s Governing Council meeting of 4 July contained the following two sentences: ‘The Governing Council expects the key ECB interest rates to remain at present or lower levels for an extended period of time. This expectation is based on the overall subdued outlook for inflation extending into the medium term, given the broad-based weakness in the real economy and subdued monetary dynamics.’ This statement, in particular the formulation ‘for an extended period of time’, marks a change in the ECB’s communication of monetary policy. It is a form of forward guidance, a communication instrument by which central banks convey their monetary policy orientation going forward, conditional on their assessment of the economic outlook.”

“To be sure, our forward guidance does not promise irresponsibility! Our purpose was not to communicate a suspension – even temporarily – of our strategy [of targeting a positive inflation rate below 2% under consideration of monetary and aggregate demand trends]. Quite the opposite: it was a sharp and definite pronouncement to reassert it. Why did we feel it was necessary to reassert our strategy? Because, starting in May and with increased intensity in the month of June, we perceived that expectations regarding the stance of monetary policy and its evolution had become somehow detached from our assessment of the state of the economy and our monetary policy inclinations, given that assessment. A sustained upward trend in money market interest rates had led to a restriction in money market credit conditions, so that a large portion of the amount of monetary accommodation that we had introduced in early May had been de facto withdrawn.”

“The expectations channel by which economic actors anticipate the path of future policy consists of two interlinked parts. The first part is an interpretation by economic actors of the strategy governing central bank actions in response to economic conditions. The second part is related to their perceptions about the central bank’s present assessment of current and future economic conditions… Forward guidance – a form of advance communication about future policy orientations – intervenes on both components of the expectations channel…[i] the central bank communicates the parameters of its reaction function and its policy goals…[ii] gives information about the central bank’s perceptions of macroeconomic fundamentals.”

“Against the conditions that we see prevailing over a meaningful horizon, our guidance includes an easing bias. This conveys the notion that we have not reached the lower bound on our key interest rates. We have not run out of ammunition. Further cuts in policy rates remain an option for the ECB if the outlook on price stability so warrants.”



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