The More Delicate Tool in the Federal Reserve’s Toolbox – Forward Guidance

Introduction

At least eight times a year, the nineteen most senior members of the Federal Reserve form the Federal Open Market Committee (FOMC) (Board of Governors, 2024). They meet in Washington, D.C., behind closed doors to revise their target for the federal funds rate (Federal Reserve Bank of Philadelphia, 2021). While the federal funds rate is a type of interest rate only directly felt by banks, its relevance stems from the rate’s impact on the types of interest rates that directly affect everyone. The interest rate for bank loans, for instance, goes up when the federal funds rate goes up (Charles Schwab, 2024). At 2 p.m. after the meeting, a press release is made to proclaim the Fed’s new target for the federal funds rate, or, colloquially, the interest rate (Board of Governors, 2024).

While the Fed’s power to wield the interest rate is well known even among the general public, far less understood is their power of public comment. What must be made clear is this: the literal words uttered by Jerome Powell in a press conference are legitimate monetary policy tools, just like interest rate changes themselves. The Fed operates under strict policies that  control and restrict communication with the public to preserve the effectiveness of this tool. For instance, when a Fed employee speaks to the public, they must make clear that their comments are their own, not a stance of the Fed’s (Federal Reserve Board, 2024).

The impact of transparency in interest rate policy can be split into two distinct effects: the consequences of communicating current interest rates and the consequences of communicating future interest rates.

Consequences related to current rate changes

I spoke with Brent Meyer, an Assistant Vice President in the Research Division at the Atlanta Fed, about the impact of transparency on the economy. 

When the Fed changes the current interest rate, it clearly communicates the exact new rate. The Fed communicates the current change to allow inflation and unemployment to be affected by the change quicker (B. Meyer, personal communication, 2024). Here, transparency plays a supporting role, as the rate change itself would still have an impact even without transparent communication.

Consequences related to future rate changes

The communication of future rate changes is called “forward guidance” (Board of Governors, 2024). Meyer gave insight into what forward guidance could do that the rate change itself could not.

Forward guidance provides direct information about future rates, which affects current inflation and unemployment rates when the public becomes aware of these anticipated changes (Board of Governors, 2024). 

Exactly how forward guidance moves its way through the markets to impact inflation and unemployment is beyond the scope of this article. What is within scope, however, is its ultimate impact. Forward guidance moves inflation and unemployment in the same direction as if the rate change it forecasts were truly implemented.

For instance, take the press release from September 2020’s FOMC meeting, when the pandemic had seriously damaged the U.S. economy. Both economic activity and employment were below their levels at the beginning of the year. Inflation was below the Fed’s target of 2 percent (Board of Governors, 2020).

The press release stated, “The Committee decided to keep the target range for the federal funds rate at 0 to 0.25 percent and expects it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee's assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time” (Board of Governors, 2020). 

This is an example of forward guidance. From this statement we can see that the impact of forward guidance is identical in direction to its real-world counterpart. First, the Committee clearly wished for a decrease in unemployment and an increase in inflation. Naturally, any forward guidance would support that goal. Second, the forward guidance told the public that interest rates would stay extremely low. Truly implementing a very low interest rate would also decrease unemployment and increase inflation (Federal Reserve Bank of St. Louis, n.d.). Thus, forecasting very low interest rates moves the economy in the same direction as actually implementing them.

Vagueness in wording

During the Committee’s meeting, the precise wording of the 2 p.m. statement is delicately crafted. The Fed is known for their often-hazy wording – this is deliberate. Vagueness leaves room for the Fed to change its future plans in a way that an explicit promise does not. Explicit promises are more binding than implicit ones. This is why, when something is explicitly promised, the words move unemployment and inflation by a greater magnitude (B. Meyer, personal communication, 2024).

Often, in other aspects of life, dropping vague hints is a poor method of communication because the other party may not pick up on the message at all. This is not the case for the Fed, with financial institutions closely examining Fed communications, hunting for signals (Wessel & Boocker, 2024). The Fed knows they do. And the institutions know that the Fed knows they do. 

Edited by Sherry Cai

References

Board of Governors of the Federal Reserve System. (2020, September 16). Federal Reserve issues FOMC statement. https://www.federalreserve.gov/newsevents/pressreleases/monetary20200916a.htm 

Board of Governors of the Federal Reserve System. (2024a, November 7). Federal Open Market Committee. https://www.federalreserve.gov/monetarypolicy/fomc.htm#:~:text=The%20Federal%20Open%20Market%20Committee%20(FOMC)%20consists%20of%20twelve%20members,terms%20on%20a%20rotating%20basis 

Board of Governors of the Federal Reserve System. (2024b, November 7). Federal Reserve issues FOMC statement. https://www.federalreserve.gov/newsevents/pressreleases/monetary20241107a.htm 

Board of Governors of the Federal Reserve System. (2024c, July 19). FAQs. https://www.federalreserve.gov/faqs/what-is-forward-guidance-how-is-it-used-in-the-federal-reserve-monetary-policy.htm 

Charles Schwab. (2024, September 16). What happens when the Fed lowers interest rates [Video]. Youtube. https://www.youtube.com/watch?v=ZWf7IXlaA1E 

Federal Reserve Bank of Philadelphia. (2021, January). A day in the life of the FOMC. https://www.philadelphiafed.org/education/a-day-in-the-life-of-the-fomc 

Federal Reserve Bank of St. Louis. (n.d.). Expansionary and contractionary monetary policy. https://www.stlouisfed.org/in-plain-english/expansionary-and-contractionary-policy 

Federal Reserve Board. (2024, January 30). FOMC policy on external communications of Federal Reserve System staff. https://www.federalreserve.gov/monetarypolicy/files/FOMC_ExtCommunicationStaff.pdf 

Wessel, D., & Boocker, S. (2024, May 9). Grading Fed communications: A 2024 survey of Fed watchers. Brookings. https://www.brookings.edu/wp-content/uploads/2024/05/2024-Fed-comms-survey.pdf

Lee, E. (2022, June 23). Jerome Powell, chairman of the US Federal Reserve, speaks during a House Financial Services Committee hearing in Washington, D.C. Bloomberg. https://www.bloomberg.com/news/newsletters/2022-07-26/forward-guidance-has-outlived-its-usefulness-for-the-fed