Working Paper

Credible Forward Guidance

Abstract: We analyze credible forward guidance policies in a sticky-price model with an effective lower bound (ELB) constraint on nominal interest rates by solving a series of optimal sustainable policy problems indexed by the duration of reputational loss. Lower-for-longer policies---while effective in stimulating the economy at the ELB---are potentially time-inconsistent, as the associated overheating of the economy in the aftermath of a crisis is undesirable ex post. However, if reneging on a lower-for-longer promise leads to a loss of reputation and prevents the central bank from effectively using lower-for-longer policies in future crises, these policies can be time-consistent. We find that, even without an explicit commitment technology, the central bank can still credibly keep the policy rate at the ELB for an extended period---though not as extended under the optimal commitment policy---and meaningfully mitigate the adverse effects of the ELB constraint on economy activit y.

Keywords: Credibility; Effective Lower Bound; Forward Guidance; Sustainable Plan; Time-Consistency;

JEL Classification: E63; E52; E61; E62; E32;

https://doi.org/10.17016/FEDS.2019.037

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2019-05-17

Number: 2019-037

Pages: 50 pages