Ben Bernanke famously remarked that “the trouble with QE is that it works in practice but not in theory”. And ahead of its adoption, many academics were sceptical that QE would have any effects at all. Yet despite QE being a part of the monetary policy landscape for nearly a decade, the bulk of academic research on QE has been on its empirical effect, with relatively little on theory and less still on normative policy questions. In a recent Staff Working Paper I develop a model which can provide answers to questions such as: “How should monetary policymakers return their instruments to more normal levels?” and “Should QE be part of the regular monetary policy toolkit?”
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.
In 1995, Fischer Black, an economist whose ground-breaking work in financial theory helped revolutionise options trading, confidently stated that “the nominal short rate cannot be negative.” Twenty years later this assumption looks questionable: one quarter of world GDP now comes from countries with negative central bank policy rates. Practitioners have been forced to update their models accordingly, in many cases introducing greater complexity. But this shift is not just academic. Models allowing for a wider distribution of future rates require market participants to hedge against greater uncertainty. We argue that this hedging contributed to the volatility in global rates in early 2015, but that derivatives can also play an important role in facilitating monetary policy transmission at negative rates.
Does fiscal policy have large and qualitatively different effects when the nominal interest rate is zero? An emerging consensus in the New Keynesian literature is that supply-side fiscal stimulus is ineffective at the zero lower bound (ZLB) while demand-side fiscal stimulus is a useful tool to escape a liquidity trap. But new evidence provided in our paper suggests that supply-side fiscal policies can play an important role at the ZLB while the effects of demand-side stimulus may be weaker than previously found.
Financial market prices provide information about market participants’ Bank Rate expectations. But central expectations can be measured in different ways. Mean expectations, derived from forward interest rates, represent the average of the range of possible outcomes, weighted by their perceived probabilities. On the other hand, modal expectations, which can be estimated from interest rate options, represent the perceived single most likely outcome. Currently, these market-implied mean and modal expectations for the path of Bank Rate over the coming few years differ starkly, with the mode lying well below the mean. In this post we argue that this divergence primarily reflects the proximity of the effective lower bound to nominal interest rates.
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.