In textbook models of monetary policy, a promise to hold interest rates lower in the future has very powerful effects on economic activity and inflation today. This result relies on: a) a strong link between expected future policy rates and current activity; b) a belief that the policymaker will make good on the promise. We draw on analysis from our Staff Working Paper and show that there is a tension between (a) and (b) that creates a paradox: the stronger the expectations channel, the less likely it is that people will believe the promise in the first place. As a result, forward guidance promises in these models are much less powerful than standard analysis suggests.
Following the Great Recession, many central banks cut their policy rates towards their lower bounds and turned to unconventional policy measures in a bid to revive their economies. That was accompanied by an increasing use of `forward guidance’ about the future path of the policy rate. In this post we summarise results from our ongoing research on `Threshold-Based Forward Guidance’, whereby the policymaker links their decision to raise the policy rate from the lower bound to outturns for particular macroeconomic variables. We show that TBFG can improve welfare at the lower bound by increasing expected future inflation and, unlike forward guidance based purely on calendar time, by shrinking the variance of possible outcomes for inflation around the target.