Forward Guidance

Using a panel of survey‐based measures of future interest rates from the Survey of Professional Forecasters, we study the dynamic relationship between shocks to monetary policy expectations and fluctuations in economic activity and inflation. We propose a small‐ scale structured recursive vector autoregression (VAR) model to identify the macroeconomic effects of changes in expectations about monetary policy. Our results show that when interest rates are away from the zero‐lower bound, a perception of higher future interest rates leads to a significant rise in current measures of inflation and a rise in economic activity. However, when interest rates approach zero, the effect on economic activity is the opposite, with significant but lagged decreases in economic activity following an upward revision to expected future interest rates. The impact of changes in expectations about monetary policy is robust when we control for other features of the transmission mechanism (e.g., long‐term interest rates, quantitative easing, exchange rate movements and even oil price shocks). Our findings also show that monetary policy expectations contribute up to 34 percent to the variability of economic activity (and 24 percent on inflation) while policy rates are fixed at the zero‐lower bound. This evidence points to the importance of managing monetary policy expectations (forward guidance) as a crucial policy tool for stimulating economic activity at the zero‐lower bound. 75201. 214-922-5262. [email protected]. We thank Nathan Balke, Andrea Civelli, Víctor Valcárcel and Mark Wynne for helpful suggestions. We gratefully acknowledge the research assistance provided by Bradley Graves and Valerie Grossman, and the support of the Federal Reserve Bank of Dallas. We base our econometric analysis on the STATA program pvar.ado of Love and Ziccino (2006). All remaining errors are ours alone. The views in this paper are those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Dallas or the Federal Reserve System. 1

We review the macroeconomic performance over the period since the Global Financial Crisis and the challenges in the pursuit of the Federal Reserve’s dual mandate. We characterize the use of forward guidance and balance sheet policies after the federal funds rate reached the effective lower bound. We also review the evidence on the efficacy of these tools and consider whether policymakers might have used them more forcefully. Finally, we examine the post-crisis experience of other major central banks with these policy tools.

The analysis in this paper was presented to the Federal Open Market Committee as background for its discussion of the Federal Reserve’s review of monetary policy strategy, tools, and communication practices. The Committee discussed issues related to the review at five consecutive meetings from July 2019 to January 2020. References to the FOMC’s current framework for monetary policy refer to the framework articulated in the Statement on Longer-Run Goals and Monetary Policy Strategy first issued in January 2012 and reaffirmed each January, most recently in January 2019.