IMF Notes

Forward guidance, or forward-looking monetary policy, is an essential part of policymakers’ toolkits, yet there is a need to carefully define its scope. Two forms of such guidance exist with a clear distinction between them: first, explicit commitments about the future path of the monetary policy stance, and second, communication about forecasts and the monetary authority’s reaction- function. Commitments to future rate paths designed for effective lower bound conditions can become costly in an environment marred by supply shocks, as seen during the postpandemic inflation period. It follows that communication about the future path of policy rates should be state dependent and embedded in frameworks organized around clear objectives and risks. More specifically, grounding communication on specific scenarios can help convey how a particular policy mix would adjust as a result of varying combinations of inflation outcomes, demand shortfalls, and indicators of financial stress. Therefore, it is possible to preserve monetary transmission, anchor expectations, and bolster accountability without creating artificially compressed market volatility or unnecessary constraints on future policy. Communicating risks adequately and clearly is key to preserving proper risk-taking incentives of financial institutions.