Abstract
The effect of forward guidance on interest rate expectations in small, open economies is often described as heterogeneous. There are examples when financial markets adjusted term structure to reflect interest rate forecasts provided in the projections published by the central banks. On the other hand, medium-term expectations can persistently deviate from trajectories presented by decision-makers, influenced by foreign monetary policy. Our aim is to find the maximal forecast horizon where the domestic forward guidance of local banks in European economies affects market interest rate expectations strongly as compared to the ECB policy. We analyzed the term structure of interest rates in Sweden, Norway, and the Czech Republic. Central banks in these three economies provide the most mature forward guidance, e.g., regularly publishing interest rate forecasts with detailed discussions. The three-month interbank rate path calculated with the Nelson-Siegel model was contrasted with both the trajectory of policy rates presented in central bank projections and that implied by the three-month EURIBOR. We found that interest rate expectations were more influenced by ECB policy than by domestic assumptions when the forecast horizon exceeds four quarters.
Highlights
In the aftermath of the subprime crisis, major central banks were forced to stimulate the economy with unconventional policies after achieving an effective lower bound on interest rates
Our goal is to find if there exists some common horizon in three European economies, when expectations about European Central Bank (ECB) policy become predominant over domestic forward guidance in navigating market expectations about future short-term interest rates
Calculations were performed on two different samples: 1) the full sample with all available quarterly observations, and 2) the subsample of quarterly observations starting from late 2012–the date corresponding to the introduction of the dot-plot by the U.S Federal Reserve and the publication of the pioneering article written by Campbell et al (2012) highlighting the importance of navigating markets through transparent communication of future rates
Summary
In the aftermath of the subprime crisis, major central banks were forced to stimulate the economy with unconventional policies after achieving an effective lower bound on interest rates. The subject literature describes a problem termed the forward guidance puzzle (Giannoni et al, 2015). The introduction of forward guidance policy was accompanied by high confidence of monetary authorities e.g. in the United States or the Eurozone. Theoretical dynamic stochastic general equilibrium (DSGE) models overestimated the response of the output gap and inflation related to interest rate expectations shocks. This class of models predicts rapid expansion of activity, when interest rate expectations are anchored below the natural rate level
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