The European Central Bank (ECB) uses its monetary policy tools to keep inflation in the euro area in line with its objective (i.e. a symmetric inflation target of 2% over the medium term). If inflation is excessively low, the ECB can reduce its key interest rates (all of which are short-term) in an attempt to bring inflation back up. However, if short-term interest rates are already at very low levels, reducing them further is not always effective, so the central bank needs other tools. Forward guidance is one of those tools.
In such circumstances, clear communication by the central bank about how and under what conditions it expects to adjust its instruments in the future (not just key interest rates, but also asset purchases, etc.) will influence the expectations of businesses, consumers, governments and other financial market participants regarding medium and long-term interest rates, which are important in determining their borrowing costs. Thanks to this guidance and the clearer picture it provides, agents can make decisions on the basis of the course of consumption and investment in the present, which in turn will influence medium and long-term rates (for more information, see How does monetary policy work?).
The ECB’s forward guidance therefore makes its monetary policy more effective and helps to achieve the main objective of maintaining price stability in the euro area.