Central banks risk being late in arresting inflation if they rely too much on forward guidance - a tool used to communicate the future path of monetary policy, a widely respected economist told policymakers at a Bank of Japan-hosted event on Wednesday.
Forward guidance is an effective tool when central banks, faced with zero short-term interest rates, want to push down long-term borrowing costs by promising to keep rates low for a long period, said Athanasios Orphanides, a Massachusetts Institute of Technology professor and a former policymaker.
"Recent experience suggests forward guidance can become a trap," Orphanides said. "Unfortunately, it's not so helpful if upside surprises in inflation materialise." "Compared to forward guidance, clearer communication of a central bank's reaction function would avoid the trap and improve policy outcomes," he added.
Central banks around the world followed in the footsteps of the BOJ in introducing unconventional monetary easing steps, including forward guidance, to combat the 2007-2008 global financial crisis.
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