Guidance counselors: the Taylor Rule and the Fed's forward guidance.

• Author: Clarida, Richard

A decade ago, discussions and debates over "forward guidance" were confined to academic seminars and the peer-reviewed pages of the American Economic Review. Fast forward to today and forward guidance is promoted by central bankers in Washington, London, Frankfurt, and Tokyo as a powerful new instrument in the toolbox of post-crisis monetary policy, policy that for several years has been constrained at the zero lower bound on nominal interest rates.

Forward guidance is designed to work a certain way in theory; however, in practice it might fall short of delivering on its bountiful theoretical promise.

What is forward guidance and how is it supposed to work?

Forward guidance is an explicit communication by a central bank that provides information today about the time path for specific policy tools in the future. Forward guidance that is successful works via familiar expectations channels, including that of the term structure that links long-maturity bond yields today to the expected path of short-term interest rates in the future. In addition, forward guidance may work by lowering the term premium on long-maturity bonds.

However, to the extent that forward guidance is not fully credible, it will not be sufficiently effective. Moreover, to the extent forward guidance raises doubts about the central bank's commitment to its inflation target, it could even increase the term premium on long-maturity bonds, negating much or potentially all of the decline in bond yields it is supposed to deliver.

Forward guidance builds on the modern theory of macroeconomic dynamics as developed by Michael Woodford and Nobel laureates Finn E. Kydland and Edward C. Prescott. In a recent survey (1) of this theoretical literature, Andrew Levin and his co-authors write, "Forward guidance regarding the future path of interest rates can be very effective in preserving macroeconomic stability ... even when the near-term path of the policy rate is constrained by the zero lower bound."

THREE KINDS OF FORWARD GUIDANCE

There are actually at least three different types of forward guidance. Guidance can be "calendar-based," "outcome-based," or guidance can convey a commitment today by the central bank to a future policy rate path that mimics or approximates the "optimal control" solution to a dynamic economic model.

Forward guidance of any type is most potent if it can credibly convey a commitment today to bind the choices of future policymakers who, when the future arrives...