Central Bank Communication in a Low Interest Rate Environment

When interest rates are low, or negative, central banks must increasingly rely on effective communication to ease the stance of monetary policy. Empirical evidence suggests that the ECB’s forward guidance, consisting of a carefully expounded series of expectations involving both key policy rates and asset purchases, has been successful in (i) reducing the sensitivity of forward rates to macroeconomic news, (ii) insulating euro area financial conditions from external shocks and (iii) providing additional monetary policy accommodation at a time when the room for cuts in key policy rates has been very limited. At the same time, a central bank cannot always be sure how its forward guidance works and much of the challenge arises from the interaction between central banks and financial markets. In this environment, and for forward guidance to be credible and effective, policymakers need to be clear about their reaction function, regularly align their policy expectations with the evolving assessment of the state of the economy and its likely evolution, and act accordingly.