Forward Guidance

Forward guidance is a central bank telling markets, in words rather than in action, what it plans to do with interest rates over the coming months or years. Because long-term borrowing costs (mortgages, corporate bonds) depend on expected future short rates as much as today's rate, a credible promise about the future can move those costs immediately, without the central bank lifting a finger on its current policy rate.

Why central banks use it

Once the policy rate is near zero, cutting further isn't possible, but a central bank can still ease by promising to keep rates low "for an extended period" or until some condition (unemployment below X%, inflation above Y%) is met. This pulls down the expected future path priced into long-term yields, which is the channel that actually matters for mortgages and business investment.

Worked example

A central bank's policy rate is 0%. Bond markets had priced in a first hike within six months, putting the 2-year yield at 1.2%. The bank then announces it will not raise rates until inflation has averaged 2% for a full year — a condition it doesn't expect to be met for at least two years. Traders re-price the expected rate path lower, and the 2-year yield falls to 0.6%, even though the policy rate itself never moved. That decline in longer yields is the guidance doing its job.