This is something I do not understand very well. I'm writing this to try to help me think about it more clearly.
Eight times a year, at each Fixed Announcement Date, the Bank of Canada does two things: it announces a target for the overnight rate until the next FAD; it provides some "forward guidance" about future targets for the overnight rate. That forward guidance receives as much attention as the current target. Here's a recent example from Kevin Carmichael at the Globe and Mail.
A good "dumb" question to ask would be: "Why does the Bank bother with forward guidance at all?"
1. Here is one simple explanation, that doesn't really work. If you looked at just one FAD in isolation, you would say that the Bank uses forward guidance because it gives the Bank more power. By saying what it plans to do over the next year, rather than just over the next 6 weeks, the Bank can shift the whole term structure of interest rates by influencing people's expectations of its own future actions.
But when you stop thinking of FADs in isolation, and see them as part of a repeated game, that simple argument doesn't work any more. The Bank only has one degree of freedom per FAD. If at each FAD it announces what it will do at the next FAD, it must then do what it said it would do, if it wants its forward guidance to remain credible. It has borrowed one degree of freedom from the future, and must then repay that loan by doing what it said it would do, otherwise nobody will believe it in future and nobody will lend it a degree of freedom again.
2. Here's a better explanation. Sure, the Bank has only one degree of freedom per FAD on average, but maybe sometimes it wants to spend two degrees of freedom at one FAD, and is willing to borrow one degree of freedom from the future and repay the loan at some future FAD by spending zero degrees of freedom. The Bank might want the extra power at some FADs much more than at other FADs. Forward guidance lets the Bank borrow extra power when it's most needed, and repay the loan when extra power is not needed.
3. Here is a quite different explanation. There is a difference between making a promise about your own future actions and making a prediction about your own future actions. Maybe forward guidance is a prediction and not a promise, and has nothing to do with borrowing degrees of freedom from the future. We are normally better than other people at predicting our own future actions. Markets normally work better when people can better predict the future. So by publishing its own predictions of its own future actions the Bank of Canada is helping markets work better.
4. Maybe it's a mixture of 2 and 3. Forward guidance is mostly a prediction, but occasionally in emergencies (like in 2009 when the Zero Lower Bound became a problem) it's a promise that borrows degrees of freedom from the future.
5. But there's something wrong with thinking that the Bank of Canada has any degrees of freedom in setting the overnight rate target. The Bank of Canada is targeting 2% inflation. If it is serious about trying to keep future inflation as close as possible to the 2% target, it cannot freely choose a target for the overnight rate. Once it has chosen the 2% inflation target, it has used up all its degrees of freedom. It has to do what (it thinks) it needs to do to hit that inflation target. If it sticks to the 2% target, any commitment becomes a conditional commitment. But then "I promise I will set the overnight rate at 1% unless I think I need to change it to keep future inflation at 2%" is no different from "I promise I will set the overnight rate at whatever I think is needed to keep future inflation at 2%, and I think 1% will work for some time". It's like making a "promise" to do whatever you think you will feel like doing. It's not a promise at all.
6. Here's yet another explanation. Maybe the Bank of Canada thinks there is a trade-off between short run and long run inflation targeting. (If I'm driving an underpowered car with poor brakes, trying to keep as close as possible to 100kms/hr, I might want to go faster than 100 when I see an uphill section ahead and go slower than 100 when I see a downhill section ahead.) In this case a conditional commitment might mean "I will set the overnight rate at 1%, even if it means inflation rises above 2% or falls below 2% in the short run, unless I think I need to change it to keep inflation at 2% in the long run."
If 6 is correct, then what the Bank of Canada is doing when it gives forward guidance is not borrowing degrees of freedom from the future, nor making a prediction of its own future actions. Instead it is announcing that it has temporarily lengthened its time-horizon for keeping inflation at the 2% target. It has borrowed a temporary extension on handing in the promised 2% inflation assignment.
It might be a mixture of 2, 3, and 6. But maybe 2 is really 6, deep down.