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peter praet : forward guidance and the european central bank column by mr peter praet, member of the executive board of the european central bank, published on voxeu. org, 6 august 2013. * * * the introductory statement to the press conference following the ecb ’ s governing council meeting of 4 july contained the following two sentences : the governing council expects the key ecb interest rates to remain at present or lower levels for an extended period of time. this expectation is based on the overall subdued outlook for inflation extending into the medium term, given the broad - based weakness in the real economy and subdued monetary dynamics. this statement, in particular the formulation “ for an extended period of time ”, marks a change in the ecb ’ s communication of monetary policy. it is a form of forward guidance, a communication instrument by which central banks convey their monetary policy orientation going forward, conditional on their assessment of the economic outlook. the standard view is that monetary policy influences the economy and, ultimately, price setting primarily by affecting interest rates at intermediate and medium - term maturities. indeed, longer - term interest rates determine the borrowing conditions that are most relevant for a large component of aggregate spending : first and foremost, durable consumption and investment. the expectations theory of the term structure of interest rates suggests that longer - term interest rates reflect the expected path of the very short - term interest rates which the central bank controls. this is because trading in financial markets removes persisting arbitrage opportunities across securities with similar risk characteristics and different maturities. as a consequence, returns are equalised across the term structure, except for premia that remunerate investors holding relatively longer term securities. therefore, it is not so much by changing their very short - term interest rate instruments that central banks can impact the decisions that matter most for the economy. it is rather by influencing expectations about the evolution of those short - term interest rates in the predictable future. when a central bank changes its short - term interest rate, interest rates at intermediate to medium - term maturities tend to shift in the same direction, if there is a signal that the new level of the short - term interest rate is likely to persist1. in general, this puts a premium on the way central banks communicate about, or at least are perceived to reveal their policy orientation. is there evidence supporting the contention that central banks ’ perceived orientation is as important as their actions? answering this question is difficult. first, when a central bank communicate