Forward Guidance Research Articles

The macroeconomic effects of forward communication

This paper provides an empirical assessment of the power of forward guidance at different horizons, shedding new light on the strength of the “forward guidance puzzle”. Our identification strategy allows us to disentangle target and forward guidance shocks from central bank private information. We investigate to what extent the horizon of guidance matters for its macroeconomic effects, and find that as the communication horizon lengthens, its impact on output and inflation weakens. This runs contrary to the prediction from standard New Keynesian models that the power of forward guidance increases with its horizon.

The Delphic forward guidance puzzle in New Keynesian models

When the central bank has information that can help the private sector better predict the future, should it communicate such information to the public? In purely forward-looking New Keynesian models, such Delphic forward guidance unambiguously reduces ex ante welfare by increasing the variability of inflation and the output gap. We call this phenomenon the Delphic forward guidance puzzle. In more elaborate models with endogenous state variables, a combination of Delphic forward guidance and preemptive policy actions may improve welfare. However, full information revelation is generally not optimal and what information needs to be revealed is highly model-dependent.

SPILLOVER EFFECT OF THE FEDERAL RESERVE’S FORWARD GUIDANCE ON CHINA’S FINANCIAL MARKETS: FROM MECHANISM ANALYSIS TO EMPIRICAL TEST

This study analyzed the channels responsible for the spillover effect of the US Federal Reserve’s (Fed’s) forward guidance on China’s financial markets with an event study and EGARCH model with data collected over the past decade. The Fed’s forward guidance affects China’s foreign exchange, bond, stock and money markets. In the three trading days before and after the event, China’s foreign exchange market had an instantaneous reaction, the bond and stock market had lagged reactions, and the money market reaction lasted for the full event window. The Fed’s forward guidance on China’s financial market differs based on the Fed’s monetary policy, guidance type and whether the guidance content is adjusted or not.

News, noise, and Indian business cycle

AbstractNew Keynesian dynamic stochastic general equilibrium models with various specifications of technology, markup, and interest rate shocks are estimated with Indian data using Kalman filter based pure and Bayesian likelihood estimation. Preference and interest rate shocks are found to be important for output determination, whereas markup and interest rate shocks are important for inflation. News, as contained in stock market variables and arising from anticipated interest rates, affects growth of gross domestic product. Interest rate shock is anticipated at horizon of one quarter and out of total variance explained by interest rate shock, one third is due to the anticipated shock. Anticipated interest rate shock diminishes the share of preference shock in output determination. Although markup shock has a large share, its persistence is low. There is evidence that permanent component of technology is not well anticipated. Once we incorporate this, technology shocks affect output more, although they still remain much below US levels. Implications for policy include forward guidance on interest rates, less reaction to short‐term supply shocks, and allowing technology shocks to play out.

A Structural Measure of the Shadow Federal Funds Rate

<ns3:p>We propose a shadow policy interest rate based on an estimated structural model that accounts for the zero lower bound. The lower bound constraint, if expected to bind, is contractionary and increases the shadow rate compared to an unconstrained systematic policy response. By contrast, forward guidance and other unconventional policies that extend the expected duration of zero-interest-rate policy are expansionary and decrease the shadow rate. By quantifying these distinct effects, our structural shadow federal funds rate better captures the stance of monetary policy given economic conditions than a shadow rate based only on the term structure of interest rates.</ns3:p>

Forward Guidance and Corporate Lending

Abstract We suggest that forward guidance, via publicly committing the central bank to future actions and creating associated expectations, fundamentally affects bank lending decisions independently of other forms of monetary policy. To test this hypothesis, we build a forward guidance measure based on the language used in the Federal Open Market Committee meetings and match this measure with syndicated loans. Our results show that expansionary forward guidance decreases corporate loan spreads and that this effect is stronger for well-capitalized banks lending to riskier firms. Forward guidance also affects nonprice lending terms, such as covenants, performance pricing provisions, and the loan syndicate structure. Additionally, banks tend to initiate new lending relationships with lower spreads after forward guidance issuance.

Dynamic Impact of Unconventional Monetary Policy on International REITs

In this paper, we estimate the dynamic impact of unconventional monetary policy in the US on international REITs. Unlike existing studies which are limited to conventional policy tools and undertake a static approach, we use an event study approach and estimate a time-varying parameter model to investigate the dynamic impact of forward guidance (FG) and large-scale asset purchases (LSAP) shocks on the international REIT returns. We also compare the effects of these unconventional tools with the effects of conventional federal funds rate (FFR) shocks. The results show that the response of international REITs to unconventional policy shocks depends on the time under consideration. FG shocks have greater time-variation in the impact on REIT returns compared to LSAP shocks, particularly with Australia, Belgium, and the US REIT markets. Furthermore, FG shocks broadly have a negative impact on REITs while the results for LSAP effects are mixed. We also find that in most countries, REITs time-varying response of FG shocks is related to changes in gold prices and financial conditions.

International spillovers of forward guidance shocks

SummaryWe estimate a two‐country model of the United States and Canada over the post 2009 sample to study the cross‐country spillovers of forward guidance shocks. To do so, we propose a method to identify forward guidance shocks during the fixed interest rate regime. The estimated forward guidance shocks coincide with significant U.S. monetary policy announcements such as the introduction of calendar‐based guidance in 2011. While a 2‐quarter expansionary forward guidance shock decreases Canadian output by about 0.2% to 0.4% on impact, we find that the United States and Canada were both better off by responding with expansionary monetary policy to the large contractionary shocks that took place during the Great Recession. The central message of our paper is that the focus on whether monetary policy spillovers are expansionary or contractionary is incomplete. What matters is whether the combined monetary policy response is stabilizing in aggregate.

Quantitative or Qualitative Forward Guidance: Does it Matter?*

Every monetary policy decision by the Reserve Bank of New Zealand (RBNZ) is accompanied by a written statement about the state of the economy and the policy outlook, but only every second decision by a published interest rate forecast. We exploit this difference to study the relative influences of qualitative and quantitative forward guidance. We find that announcements that include an interest rate forecast and announcements that only include written statements lead to very similar market reactions across the yield curve. Our results imply that central bank communication is important, but that the exact form of that communication is less critical.

Monetary policy shocks identified using the entire yield curve: an alternative approach

ABSTRACT Conventional monetary policy (MP) shocks are typically identified as unexpected changes in the short end of the yield curve. During the zero lower-bound period, central banks attempt to provide stimulus by operating on the long end of the yield curve with new tools, such as forward guidance and large-scale asset purchase. This implies that the identification of MP shocks should be done throughout the entire yield curve. This study proposes an alternative approach to analysing the effects of MP shocks, using factor-augmented vector autoregression (FAVAR) of monthly data. We therefore used information from large datasets and made changes over the entire yield curve as shocks to the VAR, which were identified using external high-frequency instruments. Furthermore, empirical analyses using economic and financial variables showed that contractionary yield curve changes decrease the inflation rate and increase risk aversion and uncertainty, which is consistent with conventional wisdom.

Monetary policy strategies for the European Central Bank

We develop a behavioral DSGE model which addresses the forward guidance puzzle. We then use the estimated model to assess if unconventional monetary policy tools such as negative interest rates, forward guidance, and asset purchases can provide efficient macroeconomic stabilization in a low nominal and real interest rate environment. While these tools boost output and inflation, the rebound from deep recession can still be painfully slow. Makeup strategies, including average inflation and price level targeting, can further support recovery and reduce downside risks, though the benefits are quite modest under behavioral expectations.

Supervisory Forward Guidance: The Effectiveness of the 2020 Supervisory Capital Relief on the Bank Credit Supply Channel

We investigate the effectiveness of the Single Supervisory Mechanism’s (SSM) capital relief measures in response to the outbreak of the coronavirus pandemic, in terms of large non-financial corporations’ lending outcomes. Using a granular borrower level dataset and controlling for the policies of other euro area authorities, bank characteristics and demand effects, we find that the Pillar 2 Guidance (P2G) capital relief had a considerable statistically significant impact in preventing a credit crunch. The results are attributed to both, the capital made available and announcement effects. The latter are generated by the communication of supervisory plans and the fact the P2G was not designed to be ex ante “releasable”. The announcement showed the supervisors’ flexibility, reduced uncertainty surrounding forthcoming regulatory responses and acted as a de facto “supervisory forward guidance” supporting bank business decisions. Going forward we propose the creation of a formal supervisory forward guidance strategy, to complement the existing communication channels, to the benefit of banks’ and market participants’ decision making during both normal and distress times. Our work therefore contributes to the literature threefold: i) it introduces a novel granular supervisory dataset at the borrower level, ii) it is the first paper to take a supervisory perspective in analysing the effectiveness of capital relief measures at the onset of the COVID-19 pandemic, and iii) it proposes a new supervisory policy instrument, the “supervisory forward guidance” with the goal of informing and steering banks’ and market participants’ expectations.

Macroeconomic stabilisation and monetary policy effectiveness in a low-interest-rate environment

The secular decline in the equilibrium real interest rate observed over the past decades has materially limited the room for policy-rate reductions in recessions, and has led to a marked increase in the incidence of episodes where policy rates are likely to be at, or near, the effective lower bound on nominal interest rates. Using the ECB’s New Area-Wide Model, we show that, if unaddressed, the effective lower bound can cause substantial costs in terms of worsened macroeconomic performance, as reflected in negative biases in inflation and economic activity, as well as heightened macroeconomic volatility. These costs can be mitigated by the use of nonstandard instruments, notably the joint use of interest-rate forward guidance and large-scale asset purchases. When considering alternatives to inflation targeting, we find that make-up strategies such as price-level targeting and average-inflation targeting can, if they are well-understood by the private sector, largely undo the negative biases and heightened volatility induced by the effective lower bound.

Interest on reserves, helicopter money and new monetary policy.

We build a nonlinear dynamic model with currency, demand deposits and bank reserves. Monetary base is controlled by central bank, while money supply is determined by the interactions between central bank, commercial banks and public. In economic crises when banks cut loans, monetary policy following a Taylor rule is not efficient. Negative interest on reserves or forward guidance is effective, but deflation is still likely to be persistent. If central bank simultaneously targets both interest rate and money supply by a Taylor rule and a Friedman's k-percent rule, inflation and output are stabilized. An interest rate rule policy is just a subset of a more general monetary policy framework in which central bank can move interest rate and money supply in every direction.

Unconditionally optimal Ramsey policy

We discuss a time invariant policy which delivers the unconditionally optimal outcomes in purely forward-looking models and Ramsey outcomes in purely backward-looking models. This policy is a product of interaction between two institutions with distinct responsibilities. Motivated by Brendon and Ellison (2015), we think of them as arms of government. One institution is responsible for ‘forward guidance’, setting rules which are necessary and sufficient to determine private expectations. The second institution implements optimal policy taking expectations as given. The forward guidance rules are designed to maximise the unconditional expectation of the social objectives.

Managing Households’ Expectations with Unconventional Policies

Abstract Binding lower bounds on interest rates and large government deficits limit the scope of fiscal and monetary policies to stimulate households’ spending through financial intermediaries and firms. Policy makers have thus been implementing unconventional policies that aim to increase households’ spending directly through managing their expectations. We first show theoretically and empirically that higher inflation expectations increase households’ consumption. We then design a difference-in-differences strategy to assess the effectiveness of unconventional fiscal policy and forward guidance, both of which aim to raise aggregate demand via managing expectations. Whereas unconventional fiscal policy increases households’ expectations and spending, forward guidance announcements do not

Forward Guidance, Information Frictions and Optimal Monetary Policy: A General Equilibrium Analysis with a Public Sector

This paper analyzes the optimal monetary policy in a model with a public sector when firms choose prices under incomplete information, and the government can not observe the current state perfectly. We accommodate the notion of Odyssean forward guidance in a framework with a public sector. The forward guidance measures how much the government's future policy depends on the current state. We find that the optimal monetary policy implements the social planner allocations through perfect Odyssean forward guidance. The next period risk-free rate is time-consistent and entirely determined by the current state of both the public sector and the private sector.

Resolving New Keynesian Anomalies with Wealth in the Utility Function

Abstract At the zero lower bound, the New Keynesian model predicts that output and inflation collapse to implausibly low levels and that government spending and forward guidance have implausibly large effects. To resolve these anomalies, we introduce wealth into the utility function; the justification is that wealth is a marker of social status, and people value status. Since people partly save to accrue social status, the Euler equation is modified. As a result, when the marginal utility of wealth is sufficiently large, the dynamical system representing the zero-lower-bound equilibrium transforms from a saddle to a source, which resolves all the anomalies.

Forward guidance and the semiotic turn of the European Central Bank

ABSTRACT This article discusses central bank forward guidance as a performative (Austin) and conative (Jakobson) practice – hence, as a form of audience-centred communication that intends to transform their behaviour when deployed by a narrator who is simultaneously also a character in the story. Taking the European Central Bank (ECB) as its primary example, the article conveys how the double role of narrator and character assumed by this institution renders it more permeable to reactions from the markets and the public. As such, ECB forward guidance is frequently misguided, with its communicative imperatives indeed being ‘corrected’ and ‘reoriented’ by market actors and publics wishing to perceive the European Central Bank as behaving like an impartial and just frontline hero. While acknowledging the presence of conversational features within these reflexive communication practices, the article approaches forward guidance as an unfolding story, not only due to the relevance of the characterisation processes through which the European Central Bank is repositioned as hero or villain by its publics, but also because exemplary episodes exhibit a reminiscent quality that isolates them from their original context and opens them up to the possibility of re-activation – as indeed happened during the recent Covid-19 pandemic crisis.

International Effects of Euro Area Forward Guidance*

AbstractIn this paper, we investigate the international effects of euro rate forward guidance (FG) and compare them to spillovers from a conventional monetary policy shock (MP). We identify the forward guidance shock via a combination of zero and sign restrictions that use the relationship between expectations and observed data and additionally draw on insights from recent event studies using high‐frequency data. To address potential time variation, we use a fully flexible approach that allows to handle both drifts in residual variances and the structural coefficients. Our results show that both shocks lead to considerable international effects on output growth, inflation and equity returns. Moreover, we find that effects are stronger during the period of the global financial crisis, which is particularly true for the FG shock. This implies that monetary policy is generally not hindered in affecting the real economy by the zero lower bound. Also, shocks to expectations can have real domestic effects with international consequences.