What’s Forward Guidance?

The biggest news today in the fx market is the announcement of the forward guidance policy by the Bank of England (BoE). This initially sent the sterling down as traders awaited BoE Governor Mark Carney's statement. But after stating that there asset purchases would continue until the unemployment rate drops to 7%, traders heaved a sigh of relief at the more-hawkish-than-expected statement, boosting the value of the sterling again.

But what is forward guidance exactly? We'll give you a quick introduction to this in the following paragraphs, so read on.

What Forward Guidance Is

The BoE controls the short-term interest rate of the country. But with a forward guidance policy, the Bank makes a promise on future interest rates. In the case of Mr Carney's statement, the promise is that the BoE would keep interest rates until unemployment drops to 7%, which is expected to happen some time in 2016.

How Forward Guidance Works

Forward guidance is used as a tool when the central bank could no longer lower rates further. By promising that it would keep the low interest rates for a long period of time, the logic is that it would encourage banks to borrow more money from the Bank of England and lend money to people at low rates as well.

Forward Guidance and Quantitative Easing

In a way, forward guidance works similarly to quantitative easing. But with quantitative easing, the central bank injects money into the economy by buying bonds. This bond-buying spree would then give banks more cash, which they could then reinvest or lend to people. Forward guidance simply keeps interest rates low for a long period. Central banks could employ both QE and forward guidance at the same time, depending on their goals.

Caveats

There are, however, no exact guarantees that the BoE will maintain rates until the unemployment threshold is met. Forward guidance, therefore, is more of a tool that gives traders what to expect in the future. It is not a solid commitment that the Bank has to keep even if the economic landscape changes later on. This has already happened in Canada when Mr Carney was still governor of the BoE in 2009 when he had to raise interest rates earlier when inflation rose faster than expected. And with him at the helm of the BoE, there is always a possibility that it could happen again.