Explaining the Forward Guidance Principle

Between two central bank meetings, an economy changes for good or for worse. A central bank’s job is to interpret the economic data released between two meetings and set the monetary policy for the period ahead.

forward guidance

The time interval between two central bank meetings differs around the world. In the United States, for example, the Fed meets every six weeks. The same in the Eurozone, where the ECB (European Central Bank) also meets every six weeks.

Australia and the United Kingdom differ. The two central banks use monthly and assess the state of their respective economies.

When the ruling bodies of these central banks meet, they don’t just set the interest rate, but the overall monetary policy. Moreover, sometimes they only make sure that the economy goes smoothly, and they re-assure the market participants that everything follows a plan.

That’s forward guidance: the process of communicating to the market the next moves in such a way that no turbulences appear.

It’s not an easy task. In fact, central banks were forced to implement such measures due to the increasing importance of high-frequency trading.

High-Frequency Trading and Forward Guidance

Robots dominate trading these days, both regarding the number of orders executed, and, recently, regarding “thinking” and interpreting future market moves. Such robots or trading algorithms run thousands or more trades per second (sometimes even per millisecond), with the intention of profiting from the slightest market move.

As such, the time frames became so small that the classic pattern the human eye sees, won’t do the trick in this world. There’s no head and shoulders or rising wedge pattern visible on the one-second chart, or even lower.

If the retail traders buy and sell on trading accounts with five digits on most currency pairs (even though the 4th digit is still the one that defines a pip), for trading algorithms things look fundamentally different: they trade on the 7th digit, or even more.

Because of these algorithms and the increase in the number of trades they execute, the market fluctuated more and more in the recent years. As such, something had to happen. Enter Fed.

The Federal Reserve of the United States Moves

The Fed was the first bank to introduce the term, and the concept known today as the forward guidance principle. Its move was a bold one.

It introduced a press conference to follow every second Fed meeting. During the press conference, the Chairwoman/Chairman, explains the FOMC (Federal Open Market Committee) Statement takes a question from the press representatives.

During the press conference, it provides “forward guidance” on the next Fed moves. That’s all that matters for the Forex market as it moves based on future expectations.

A recent example happened when the Fed started the so-called quantitative tightening program (selling the bonds bought under the quantitative easing program). At the press conference, Mrs. Yellen described the process as “boring as watching an oil paint dry.”

And so, it turned out so far, with little or no reaction from the market. It means the Fed provided the right forward guidance, and the market wasn’t surprised by the move.

Conclusion

Other banks quickly followed in the same footsteps. The first one was the ECB (European Central Bank).

It changed the number of meetings in a year (from once a month to once every six weeks) and added the forward guidance.

In fact, central banks did what retail traders had to do for years: adapt to the constant changes in the Forex market.


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