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Central banks are powerful institutions. They are in charge of making sure that monetary policies don't negatively affect the economy. That's the main reason why traders listen when a central bank makes an official statement.
Forward guidance (FG) is communication by the central bank directed toward the public and investors in which the state of the economy is discussed as well as the future economic and monetary policies by the central bank.
Yes, it's a simple as that. However, it's crucial to delve into the minutiae and learn a bit more about FG as it is an important driving force in financial markets and the economy.
Understanding Forward Guidance (FG)
FG's primary purpose is to inform potential financial decisions by explaining what the central bank's plans are. Therefore, businesses, financial news outlets, investors, and traders are keen to know as to when the next FG announcement will be made. Through FG, the central bank can prepare the market for any potential downturns or upswings in the economy. And, it is in the best interest of all parties to avoid large shocks in the value of assets and commodities.
As of this writing, several large central banks provide forward guidance regularly. These banks are the US Federal Reserve, the European Central Bank, the Bank of England, and the Bank of Japan. The People's Bank of China has also been providing forward guidance, but it's not been common practice and is usually not very transparent.
There is a second reason that FG matters, and that's as an incentive. Explaining what the future monetary policy will be, comes with also ascertaining what will it take for things to change. For example, the FOMC uses forward guidance as a way to sway markets in a particular direction. The FOMC has been doing that since the Great Depression, and it has become a strategy used by other central banks.
An excellent example of using FG as a tool comes in the back of the 2008 financial crisis. Between 2013 and 2014, the FOMC used forward guidance to create confidence in the markets by expressing its desire to keep interest rates low until unemployment fell below 6.5% and inflation reached its 2% target.
Trading On Forward Guidance
Here is where everything connects. Forex and commodity traders listen to a central bank's FG as carefully as multinational corporations because, as explained before, it affects the market. Using FG is not the only fundamental data point that matters. But it shouldn't be put aside when doing fundamental trading.
Everything there is to know about interest rates, currency exchange, bond trading, and money supplied will be explained via forward guidance. Moreover, potential changes to current monetary policies will also be explained. And those probable moves affect the present.
Anything a central bank does or says it will do affects the market. Traders would make a blunder by omitting any statement given by a central bank, especially if that statement is forward guidance. The reason why the USD/EUR pair and the GBP/USD pair are as stable as they are is thanks to FG. It prepares traders for future shifts and allows the pairs to adjust to new market demands.
So whenever you want to do fundamental analysis, check for the latest forward guidance by the central bank. You'll be pleasantly surprised at how much easier your analysis will be once you take it into account.
