The term ‘forward guidance’ describes central bank communications about the likely future path of policy rates. Forward guidance is not new – central banks have been providing guidance for decades in the form of forecasts for inflation and GDP growth. What is new is that, since policy rates have been stuck at or near their lower bounds, central banks have made increasing use of explicit statements about their intentions regarding future policy.
Why have they been doing this? It is crucial to draw a distinction between two different motivations.
- The first is to convey information about how the central bank intends to set policy to meet its objectives (its ‘reaction function’). The aim is not to stimulate the economy (though that could be a by-product), but rather to make policy more effective by guiding people’s expectations to be more consistent with the central bank’s intentions.
- A second motivation is to stimulate the economy by promising to keep rates lower in future as a substitute for cuts today, which may not be possible due to a lower bound. This differs from the reaction function ‘clarification’ motive because it requires the central bank to promise above-target inflation in the future, which is a promise to deviate from its usual reaction function.
We focus on this second ‘promise’ motivation for forward guidance. In our view, forward guidance announcements made by central banks to date have been the former ‘reaction function clarification’ type rather than the latter ‘promise to deviate’ type (e.g. Bean 2013). Accordingly, this column should be read as a comment on the consequences of implementing such promises in textbook monetary models, rather than as a commentary on what central banks have actually done.
What is the forward guidance puzzle?
Textbook New Keynesian models deliver unreasonably large macroeconomic responses to forward guidance promises, a phenomenon described as the ‘forward guidance puzzle’ by Del Negro et al. (2015).
To illustrate the puzzle, we draw on analysis from our recent paper (Haberis et al. 2017). We use a textbook model of the output gap, inflation, and the policy rate in which expectations about the future play a large role in households’ and firms’ decision making. Policy is set optimally under discretion – the policy rate is set to minimise welfare costs arising from (current and future) deviations of output from potential and inflation from target. (Ordinarily) the policymaker cannot commit to future policy actions that would be inconsistent with minimising welfare costs at that future time.
We construct a scenario in which a large shock forces the policy rate to the zero lower bound (ZLB). The shock creates a deep recession because policy cannot be eased enough to offset it, given the ZLB constraint, and the presumed absence of other policy measures, such as asset purchases. We then examine attempts to improve outcomes using forward guidance promises to hold rates at the ZLB for longer than implied by the policymaker’s usual reaction function.
Figure 1 Effects of fully credible forward guidance policies
Notes: The model starts in its steady state and is hit by a large recessionary shock. In the baseline (black lines), interest rates are lowered to the ZLB, where they remain until quarter 7. The other two lines show the effects of two fully credible forward guidance policies – a promise to hold interest rates at the ZLB for an extra three quarters (blue lines), and a promise to hold interest rates at the ZLB for an extra four quarters (red lines).
Figure 1 shows the results, under the standard assumption that the promises are fully credible. The solid black lines show the baseline scenario, in which the policy rate is constrained at the ZLB for 7 quarters following the shock. The dotted blue and dashed red lines show the effects of promises to hold rates at the ZLB for an additional 3 and 4 quarters respectively. The simulations illustrate the standard result that forward guidance in textbook models can ameliorate the recession resulting from the combination of a bad shock and the ZLB. They also demonstrate that a marginal extension in the duration of the promise (from three to four quarters) can have a large effect.
It is not unreasonable that a policy that successfully lowers long-term real interest rates could stimulate activity and inflation. The question is whether the effect is sufficiently powerful to constitute a puzzle. Del Negro et al. (2015) use the Federal Reserve Bank of New York’s model – a more empirically reasonable model than the textbook model used above – to show that its responses to policies of this sort are much stronger than equivalent empirical estimates. Given that the transmission mechanism underlying this result is common to most monetary policy models, the forward guidance puzzle is also common to most models in that class.
This puzzle has prompted economists to develop models that deliver more empirically reasonable responses to forward guidance promises (see Del Negro et al. 2015 for a review). We take the complementary approach of retaining the textbook model, but challenging the assumptions underpinning the experiment. We argue that the puzzle contains a paradox, which our analysis illuminates.
The time-inconsistency of forward guidance promises
The cost of using forward guidance promises to reduce the size of a recession is an overshoot of the inflation target after the recession has ended. At the time of the announcement, this cost appears worth paying because the recession is smaller. As time passes, however, the benefits of the smaller recession become history, leaving only the cost of the overshoot.
This well-known ‘time-inconsistency’ effect is shown in the bottom right panel of Figure 1. The promises to hold rates at the ZLB for three and four additional quarters both improve welfare immediately after the announcements. But, shortly thereafter, both promises deliver worse outcomes than in the baseline scenario in which there was no forward guidance policy. At this point, the policymaker has an incentive to renege on their original promise.
For this reason, forward guidance of this sort is sometimes called ‘Odyssean’. The policymaker needs to commit to stay the course, just as Odysseus resisted the sirens’ calls by having himself bound to the mast of his ship. In the real world, central banks do not have the ability to tie themselves to the proverbial mast, so the standard assumption that the policymaker would definitely follow through with the promise is questionable.
Imperfectly credible forward guidance promises
We can incorporate scepticism about the policymaker’s ability to commit into our simulations by assuming that the private sector attributes some probability to the policymaker reneging whenever they have an incentive to do so (as measured by welfare). We assume that the probability is increasing in the size of the renege benefit. Figure 2 shows the results.
Relative to the perfect credibility case (Figure 1), the most striking difference is that the two forward guidance policies now have very similar economic effects. The attenuation of stimulus is larger in the case of the longer-duration promise because the larger overshoot associated with that promise increases the policymaker’s temptation to renege on it, making it less credible (bottom-right panel). Attempts to add more stimulus by increasing the duration of the promise yet further would be futile in the absence of more credibility.
This imperfect credibility mechanism is not just a theoretical possibility, it has also been recognised by policymakers (see Nakata 2015 for a review).
Figure 2 Effects of imperfectly credible forward guidance policies
Notes: The model starts in its steady state and is hit by a large recessionary shock. In the baseline (black lines), interest rates are lowered to the ZLB, where they remain until quarter 7. The other two lines show the effects of two imperfectly-credible forward-guidance policies – a promise to hold interest rates at the ZLB for an extra three quarters (blue lines), and a promise to hold interest rates at the ZLB for an extra four quarters (red lines). The bottom right panel shows the per-period probability that the policymaker reneges on the announced promise.
Imperfect credibility and the forward guidance puzzle
What does this mean for the forward-guidance puzzle? Figure 3 shows simulations of the same four-period lower-for-longer policy assuming imperfect credibility in two alternative versions of the model: the one used above, and a version in which decisions are less sensitive to announcements about future interest rates (following Gabaix 2016).
By construction, the forward guidance promise is less powerful under perfect credibility in the model with higher discounting (the dashed lines). But the effects are very similar in the two models when we relax the perfect-credibility assumption (the solid lines). There is a link from the potential power of forward guidance promises to their credibility – the greater the potential power of the promise, the less likely it is to be credible and the greater the attenuation in the macroeconomic effect. The result is that a forward- guidance puzzle may no longer exist.
Figure 3 Effects of imperfectly credible forward guidance policies in two alternative models
Notes: The model starts in its steady state and is hit by a large recessionary shock. In the baseline (black lines), interest rates are lowered to the ZLB, where they remain until quarter 7. The effects of a forward-guidance announcement to hold interest rates at the ZLB for an extra four quarters are shown for the base model (green lines) and an alternative model in which demand and inflation are less sensitive to forward guidance announcements (red lines). In both case, the dashed lines show the full-credibility case and the solid lines show the imperfect-credibility case. The bottom right panel shows the per-period probability that the policymaker reneges on the announced promise in the imperfect credibility case.
The forward guidance puzzle contains a paradox. It is the combination of a strong effect of expected future real interest rates on current activity and the assumption of perfect credibility that gives forward guidance promises such power in textbook models. We have highlighted an internal inconsistency at the heart of the puzzle because a more powerful transmission channel is likely to go hand in hand with a less credible promise.
Using forward guidance promises to stimulate the economy is an idea dating back to Krugman (1998). The likelihood that a forward guidance promise of this type would lack full credibility in the absence of an appropriate commitment mechanism is one reason why central banks have not attempted to use forward guidance in this way.
Bean, C (2013), “Global aspects of unconventional monetary policies”, Federal Reserve Bank of Kansas City Symposium, Jackson Hole.
Del Negro, M, M Giannoni, and C Patterson (2015), “The forward guidance puzzle”, Staff Reports 574, Federal Reserve Bank of New York.
Gabaix, X (2016), “A behavioural New Keynesian model”, NBER Working Paper No. 22954.
Haberis, A, R Harrison, and M Waldron (2017), “Uncertain forward guidance”, Bank of England Staff Working Papers 654.
Krugman, P (1998), “It’s baaack: Japan’s slump and the return of the liquidity trap”, Brookings Papers on Economic Activity 29 (2): 137-206.
Nakata, T (2015), “Credibility of optimal forward guidance at the interest rate lower bound”, FEDS Notes, Board of Governors of the Federal Reserve System.