Why should the FOMC provide systematic forward guidance?


Nov. 20 2020, Updated 1:37 p.m. ET

Charles Plosser speaks on rules-based forward guidance at the Council on Foreign Relations, New York

Dr. Charles Plosser, President and Chief Executive Officer of the Federal Reserve Bank of Philadelphia, spoke at the Council on Foreign Relations in New York on May 8, 2014. The topic for discussion was “Communication and Transparency in the Conduct of Monetary Policy.” In the last part, we discussed Dr. Plosser’s views on communicating changes in the Fed funds rate. In this part, we will discuss aspects of his speech relating to a rules-based or systematic approach to forward guidance.

What is forward guidance?

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As per the U.S. Federal Reserve, “Through forward guidance, the Federal Open Market Committee provides an indication to households, businesses, and investors about the stance of monetary policy expected to prevail in the future. By providing information about how long the Committee expects to keep the target for the federal funds rate exceptionally low, the forward guidance language can put downward pressure on longer-term interest rates and thereby lower the cost of credit for households and businesses, and also help improve broader financial conditions.”

Charles Plosser speaks on the role of forward guidance

According to Charles Plosser, “Forward guidance is not a separate or independent tool of policy. Its effectiveness is intimately related to other features of monetary policy. In particular, a credible, systematic approach to policy and the general openness and transparency of the policy process are essential elements in shaping expectations. Even with this recognition, there are various views about how best to communicate information about the intended path of policy and how to ensure that such information is credible. If it is not credible, then it will not shape expectations in a beneficial way.”

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Central banks around the world provide important economic updates on the state of the economy, and their risk assessments on and their outlook for key economic variables. The latter are the most important aspects of the central bank communication, as these variables determined decisions on monetary policy, both current and future. So, the communication on how these variables systematically determined the policy was very important.

In his remarks, Dr. Plosser said, “I want to stress the importance of the FOMC articulating such a systematic approach to policy. Doing so is likely to make forward guidance more effective, by helping the public to better interpret what that guidance means.”

How does FOMC communication impact financial markets?

The Dow Jones Industrial Average (DIA) climbed to a new record of 16,580.85 after the Fed concluded its FOMC meeting on April 30. After the meeting, the Fed announced it was scaling back asset purchases by $10 billion per month, to $45 billion per month, citing “cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program.” The S&P 500 Index (SPY) climbed 0.3%, to 1883.95.

The 30-year Treasury yields (TLT) fell by 2 basis points to 3.47% following the FOMC announcement, on comments that the Fed would keep the base rate between 0% and 0.25% for a “considerable period” after asset purchases end. Bond markets interpreted this as a signal that monetary tightening wasn’t imminent, and low rates would stay in the near future. The prices of the iShares Core Total U.S. Bond Market ETF (AGG) rose 0.2%, to $108.39. The prices of the PowerShares Insured National Municipal Bond Portfolio (PZA) rose 0.16%, to $24.39.

Read The Fed funds rate: Why the Fed’s “dots” moved markets to know more about how FOMC announcements impact financial markets.

In the next part, we will discuss Charles Plosser’s views on secrecy versus transparency in monetary policy guidance.


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