The Role of Forward Guidance in Inflation Expectations Flashcards
What is forward guidance?
A monetary policy tool where central banks communicate their future policy intentions to shape market expectations.
What are the traditional tools that forward guidance complements?
Interest rates and quantitative easing (QE).
When is forward guidance particularly useful?
When nominal interest rates are at or near the zero lower bound (ZLB).
What is the primary aim of forward guidance?
To anchor inflation expectations and influence economic behavior in the present.
Fill in the blank: Forward guidance serves as a complement to traditional tools like _______ and QE.
interest rates
True or False: Forward guidance is used only when interest rates are high.
False
What does forward guidance provide to shape market expectations?
Explicit signals about future policy actions.
What is forward guidance?
A tool used by central banks to influence long-term yields by shaping expectations about future short-term interest rates.
It is crucial for guiding economic decisions related to borrowing and investment.
How do long-term borrowing costs relate to forward guidance?
They are heavily influenced by expectations of future monetary policy stance.
This includes costs for mortgages and corporate investments.
What happens when the Bank of England signals that interest rates will remain low?
Bond yields may decline, encouraging investment and economic expansion.
Lower borrowing costs typically stimulate economic activity.
What occurs if the Bank of England signals future rate hikes?
Long-term interest rates may rise, leading to lower investment and consumption, thereby reducing inflationary pressures.
Higher rates can deter borrowing and spending.
What interest rates did the Bank of England set after the Global Financial Crisis?
Cut to 0.5% in 2009, and later to 0.25% in 2016.
This was in response to economic conditions following the crisis and Brexit referendum uncertainty.
Why did the Bank of England rely on forward guidance post-2008?
To reassure markets that rates would stay low ‘for an extended period’ to stimulate borrowing and economic recovery.
This was crucial given the proximity to the Zero Lower Bound (ZLB).
What effect did forward guidance have on inflation expectations?
It anchored inflation expectations, preventing deflationary spirals.
Anchoring expectations can stabilize the economy during downturns.
Fill in the blank: Forward guidance is used by central banks to influence _______.
[long-term yields].
True or False: Forward guidance can help prevent deflationary spirals.
True
By anchoring inflation expectations.
What is the purpose of forward guidance in an inflationary environment?
To curb expectations of persistent inflation
Forward guidance is a communication tool used by central banks to influence financial conditions.
What happens when the BoE signals aggressive future rate hikes?
Financial markets adjust by pricing in higher future rates, leading to higher bond yields and borrowing costs today
This adjustment can discourage excessive credit growth.
How does forward guidance affect credit growth and speculative activity?
It discourages excessive credit growth and speculative activity, reducing inflationary pressures
This is achieved through increased borrowing costs.
What was the inflation rate in the UK in 2022?
Surged past 10%
This was significantly above the BoE’s target of 2%.
What event contributed to the inflation surge in the UK in 2022?
Post-COVID recovery and energy price shocks from the Russia-Ukraine war
These factors created significant supply and demand imbalances.
What type of guidance did the BoE provide in response to the inflation surge?
Hawkish forward guidance
This indicated a series of planned rate hikes.
What was the effect of the BoE’s hawkish forward guidance on market-based inflation expectations?
It contributed to a fall in market-based inflation expectations
This indicates that markets believed inflation would be controlled.
What trend was observed in UK Gilt yields in late 2023?
A decline in UK Gilt yields
This decline suggests that forward guidance helped anchor long-term inflation expectations.
What is one strength of forward guidance?
Transparency & Predictability – Enhances the credibility of central banks, reducing uncertainty.
How does forward guidance influence long-term rates?
Affects expectations of monetary policy over years, not just months.
Why is forward guidance effective at the ZLB?
Provides a monetary stimulus when rate cuts are no longer an option.
What is a key weakness of forward guidance?
Credibility Risk – If a central bank fails to follow through on guidance, market confidence may weaken.
What does data dependency mean in the context of forward guidance?
If economic conditions change unexpectedly, forward guidance may be ineffective or require revision.
Fill in the blank: Forward guidance is limited in responding to _______.
Inflationary Shocks
What are examples of situations where forward guidance may be limited?
Supply-side inflation (e.g., 1970s oil shocks, 2022 energy crisis)
What is forward guidance?
A monetary policy tool used to communicate future policy intentions to influence economic expectations
Forward guidance aims to shape the expectations of households and businesses regarding future interest rates.
What has been the dominant monetary policy framework since the 1990s?
Inflation targeting
Inflation targeting focuses on maintaining a specified level of inflation.
When did the UK formally adopt inflation targeting?
1992
The UK adopted a 2% CPI target after exiting the Exchange Rate Mechanism (ERM).
What was the inflation target set by the UK in 1992?
2% CPI target
This target was later transferred to the independence of the Bank of England in 1997.
What event in 2008 increased the prominence of forward guidance?
Global Financial Crisis (GFC)
The Zero Lower Bound (ZLB) constraint during the crisis led to a greater reliance on forward guidance.
What period saw a significant inflation crisis addressed by the Bank of England?
2021–2023
During this period, the BoE used both forward guidance and rate hikes.
How did the Bank of England address inflation expectations during the 2021–2023 inflation crisis?
Combined forward guidance and rate hikes
This strategy aimed to regain control over inflation expectations.
