What is the purpose of forward guidance during rate hikes?

Question

It seems the primary purpose of forward guidance is to stabilize long term interest rates, even when the Fed has only control over short term rates. It is especially useful for when the BOJ and Fed have reached the zero lower bound, and would like to provide further easing---this can be accomplished by telling people that the Fed will continue to keep rates low.

From Bernanke's 21st Century Monetary Policy:

A 2005 paper by Refet Gürkaynak, Brian Sack, and Eric Swanson estimated that, from 1990 to 2004, more than three-fourths of the changes in five- and ten-year Treasury yields following FOMC statements and other Fed communications resulted, not from unexpected changes in the funds rate itself, but from new guidance (explicit or implicit) about the future direction of the funds rate. As we’ve seen, the FOMC’s reliance on forward guidance became much greater after 2008 when the lower bound limited the ability of policymakers to add stimulus through short-term rate cuts.

But, what is the purpose of Fed forward guidance during rate rises, where there is not a symmetric upper bound? Why is it not more appropriate to raise rates to the Fed's intended long term destination immediately, as opposed to giving forward guidance, and then doing so?

Answer 1

There are usually strong reasons to distrust quick and large rate hikes. Incrementalism is largely the name of the game in monetary policymaking, as it tends to avoid overshooting the mark and avoid introducing additional volatility.

Interest rate hikes do not only affect the macroeconomy, but also the financial sector, and so large and sudden shifts can cause financial instability. Households with variable rate mortgages would be severely impacted by such a shift. Firms can be affected via other types of loan.

Conventional modern macroeconomics states that expectations of future inflation are important in determining inflation itself. Forward guidance on interest rate is, much like having an inflation target in the first place, a way of controlling inflation expectations. This effectively allows controlling inflation itself, without having to make as many difficult policy decisions.

It is therefore often preferable to utilise forward guidance alongside incremental changes to policy, over a single sudden shift in policy.