The Economist explains: What “forward guidance” is, and how it (theoretically) works

Posted: February 12, 2014 in economy
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IN DECEMBER 2012 Ben Bernanke, then chairman of the Federal Reserve, reached deep into the central banker’s bag of tricks and pulled out something novel. Using a new trick which became known as “forward guidance”, the Fed declared that it would not raise interest rates until America’s unemployment rate dropped to at least 6.5%, so long as inflation remained below 2.5%. In August 2013 the Bank of England followed suit. Mark Carney (pictured), its governor, promised to leave rates low until unemployment was down to at least 7%—again, so long as inflation and financial markets remained well behaved. In both America and Britain, unemployment fell quickly toward the thresholds. Yet neither central bank reacted by moving to boost rates, leading critics to argue that forward guidance had failed and should be scrapped. Central banks are instead tweaking their guidance: the Bank of England will update its guidelines on February 12th, and the Fed may soon do the same. What is the aim of forward guidance, and how is it supposed to work?The goal of monetary policy is to smooth out macroeconomic wobbles by co-ordinating market expectations. Central banks want companies to be bullish enough to invest and hire willing workers, but not so exuberant that inflation begins to pick up. For most of the past generation, central banks performed their co-ordinating task by fiddling with …

via Economic Crisis


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