ABSTRACT
There is substantial disagreement among both policy makers and academics about the merits of forward guidance for monetary policy. Consequently, practice regarding forward guidance varies significantly across central banks and over time. Many central banks divulge nothing about the future actions they are likely to take. As documented by Geerats et al. (2008), the ECB currently uses a traffic-light system with different code words in order to signal its likely decisions in the near future. The Federal Reserve has experimented with different practices. In May 1999 it started publishing a policy bias or policy tilt, but this was discontinued after one year.1 In 2003 the Fed embarked on a new attempt to issue forward guidance. The central banks of Iceland, New Zealand, Norway and Sweden are much more explicit and publish numerical values for the future path of interest rates. In this chapter we summarise the arguments for and against the desirability of forward guidance put forward in the literature and assess their validity in the context of various frameworks. We focus on forward guidance through interestrate projections. Forward guidance can serve two purposes, representing either a commitment device or a means of communication. We point out that there are limits to the communication of private information through forward guidance. If forward guidance represents cheap talk, the precision of the information transmitted by the central bank is limited by credibility problems. If forward guidance is used as a commitment device, a trade off arises between gains from commitment and losses in flexibility. The chapter is organised as follows: in the next two sections we summarise the main arguments in favour of and against forward guidance. We provide an assessment of these arguments for different scenarios in Section 3. Section 4 concludes.
