Financial Market Responses to the Policy Language of Forward Guidance: Evidence from China

Abstract

Forward guidance is an innovative unconventional monetary policy tool used to manage expectations. This study not only investigates whether and how forward guidance influences financial markets but also explores its impact on cross-market correlations. Three key findings include: (1) larger absolute change in tone increases currency market volatility but decreases treasury bond and stock market volatilities. The noise-reducing effect is primarily attributable to forward guidance on economic outlook rather than policy inclination, although their effectiveness has reversed since 2015. (2) A positive change in forward guidance tone decreases currency market interest rate, which is economically negligible, albeit statistically significant. Returns of other financial assets are not responsive to the change in forward guidance tone. (3) Forward guidance significantly influences cross-market correlations though the impacts show heterogeneity. Economic-outlook and policy-inclination forward guidance significantly affect the currency-bond correlation in the same direction while exert differential impacts on bond-stock and currency-stock correlations. Two important implications for expectation management are enhancing coordination between different types of forward guidance as well as improving the efficiency of information transmission in communication.