Volatility falls, for the time being, as market participants naturally position themselves around this bet, often using significant leverage to do so. So, what happens when circumstances change, as they inevitably do? What happens when investors start to consider the possibility that the guidance will change?
The positions that are stacked around the central bank’s guidance unwind, and all that suppressed volatility suddenly resurfaces in financial markets, often to levels that surpass historical averages. That’s when we pay the price of forward guidance. To be sure, when the policy rate is at the effective lower bound, the benefits of forward guidance can easily outweigh the costs.