If I read Stephen Poloz correctly, the Bank of Canada will not normally be doing forward guidance in the future. But it will use forward guidance in an emergency. I do not clearly understand Steve's reasoning (see section 7 of his discussion paper), but I think this is the right decision.
"Forward guidance" is a misleading term. An inflation-targeting central bank, like the Bank of Canada, always does "forward guidance" for inflation. The Bank of Canada tells people that it is committed to the 2% inflation target. It always wants to guide expectations of future inflation back towards the 2% target, and keep them there.
But "forward guidance" has come to mean guiding expectations about the path of the Bank of Canada's policy interest rate.
There are two reasons why I think Steve's decision is the right one:
1. Because the Bank of Canada is committed to keeping inflation at the 2% target. It has no commitment to any particular rate of interest. The rate of interest it sets, temporarily, is just a means to an end. That end is the 2% inflation target. "Forward guidance" takes attention away from the inflation target and directs it towards the interest rate instrument. It suggests, misleadingly, that the two forms of "guidance" are on an equal footing. They are not.
2. As I have argued in a previous post, forward guidance is a way of borrowing degrees of freedom from the future. Borrowing power from the future might be a better way of saying this. In an emergency, when you need as much power as possible, it makes sense to borrow power from the future. But when the emergency is over, it makes sense to repay that loan of power. So that if another emergency arises in future, you can once again borrow power up to your credit limit.
The Bank of Canada has 8 Fixed Announcement Dates per year, at which it announces the policy interest rate that will be in place until the next FAD. So there are 8 "periods" per year.
On average, the Bank of Canada has one decision per period. On average, it has one unit of "power" per period. But that is only true on average. In an emergency, if it wants to, the Bank can make two decisions in one period. It can use two units of power in one period. It can announce the interest rate for this period; and it can announce the interest rate for next period too. Or it can make three decisions, using three units of power, in one period, by announcing the interest rate for this period, and the next period, and the period after that.
Forward guidance gives the Bank of Canada extra power. But that extra power is only temporary. Because the following period it must do what it promised to do in the previous period, or else it will lose credibility, and lose the ability to borrow power in future. Unless it goes deeper and deeper into debt, by making promises about what it will do in the more and more distant future, it can only make one decision per period, and use one unit of power per period, on average. For every period where it makes two decisions, there must be a period where it makes zero decisions.
By doing this period what it promised to do last period, and making no promises about what it will do next period, the Bank of Canada is repaying its past loan of borrowed power, rather than rolling over that loan. By paying off its debt of past forward guidance, it is once again free to borrow power from the future, should another emergency arise.
Worthwhile Canadian Initiative 
I like the analogy.
Nothing new here, but airing my understanding – It seems to me however, that by borrowing a decision from the next FAD (Period+1 or P1), the CB must give up data dependence in P1. Interest Rate forward guidance for P1 removes the option to commit to inflation targeting in the decision at P1. Put in the extreme, to fulfil its promise for P1 and keep credibility that it will use instruments as promised, the CB must give up (if only a little bit) its promise to of a data dependent use of instruments for inflation targeting.
Now that’s way over extreme, but gets at why forward guidance is unhelpful during normal times. In normal times, the CB should promise to be flexible!
Sometimes however, it might make sense to pick rate promises over inflation targeting promises. A) if CB is confident at P0 that they would pick rate R1 at P1 anyway, it makes sense to announce that; B) if the CB believes that the representative agent’s expectation of the CB’s data dependent behaviour doesn’t match the CB’s expectation of its own behaviour then it makes sense to try to pre-announce that behaviour (with the assumption that the even if circumstances change, they can make up for it in P2).
Sqeeky: Glad you liked the analogy. I was hoping it would work.
Suppose that demand this period depends both on this period’s r and on expectations of next period’s r. Which is a reasonable assumption. In one parallel world the central bank always sets this period’s r. In the second parallel world the central bank always sets next period’s r. It is not obvious to me which of the two central banks would be able to keep inflation closer to target. And it is not obvious to me what the answer to that question would depend on. The second central bank is more reliant on its credibility though. [edit: see my next post on that question.]
Quite right: the BoC has standing “forward guidance” that inflation rates will be 2%. Forward guidance under the name applies to interest rates.
But what can this mean? That the Bank is offering guidance on both inflation and interest rates simultaneously? I think not; it can only mean that the guidance on interest rates will supersede that on inflation rates during the forward guidance period. Can this commitment be unconditional? Again, I think not; were realized inflation rates to reach, say, 30% the commitment would surely be broken.
So “forward guidance” on interest rates really means something like “during the next x months we are temporarily willing to tolerate inflation rates a little higher than 2% before we raise our policy interest rates. But we won’t tell you how much higher. 3%? 4%? We’ll let you guess for yourself.”
My opinion is the bank would be better off simply modifying its forward guidance on inflation directly; something like “we would like to see inflation hit 3% for 6 months or 4% for 3 months before we return to a 2% target.
The reason they don’t do this is likely political; deliberately targeting higher inflation is unpopular. Again, in my opinion this is misguided; the reason is that successful policy will require the realization of higher inflation rates in any case.