Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Has Forward Guidance Been Effective?

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Has Forward Guidance Been Effective?

Article excerpt

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Since 2008, the Federal Reserve has relied on unconventional policy measures to fulfill its dual mandate. These unconventional tools became necessary when the effective lower bound on nominal rates prevented further cuts in the target federal funds rate. One such tool used in the aftermath of the Great Recession has been forward guidance, which is communication about the future path of policy rates. But has forward guidance, as recently practiced by the Federal Open Market Committee (FOMC), been effective?

Economists have yet to reach a consensus on whether forward guidance is an effective substitute for changes in the target federal funds rate. Forward guidance is similar to conventional policy in that it provides information about short-term interest rates which affect broader interest rates that influence spending by consumers and businesses. However, forward guidance differs from conventional policy in that it carries a greater risk of being misinterpreted (Woodford). Statements that extend the duration of exceptionally low rates may be perceived as a revised forecast of a bleaker economic outlook. Consequently, forward guidance may actually reduce economic sentiment and, in turn, lower aggregate demand.

This article shows that forward guidance, as practiced by the FOMC since 2008, has had similar effects on the economy as past changes in the target federal funds rate. Policy guidance signaling that the federal funds rate would remain lower in the future than previously expected has led to increases in employment and prices. Moreover, the peak effects on employment and prices following a typical forward guidance announcement are quantitatively similar to those that followed a typical change in the effective federal funds rate before the zero lower bound became a binding constraint on conventional policy.

One caveat to these conclusions is that our empirical analysis is unable to disentangle the relative contribution of quantitative easing (QE) from the estimated effects of forward guidance. Woodford, among others, suggests QE acts as a signal to the public affirming the FOMC's commitment to its interest rate guidance. Increases in QE may have therefore played an integral role in generating the estimated stimulatory effects of guidance about lower future rates. This is especially plausible since the FOMC statements and transcripts analyzed in this article illustrate that some members of the Committee were hesitant to make policy commitments that would constrain monetary policy in the future.

Section I reviews various channels through which forward guidance can influence economic activity and documents the FOMC's intent behind its recent forward guidance. Section II presents evidence that FOMC forward guidance about lower future rates increases employment and prices and compares these estimates with the effects of changes in the effective federal funds rate prior to the zero lower bound period. Section III concludes with a discussion of the limits of forward guidance as a tool to stimulate the economy when the federal funds rate is constrained by the zero lower bound.

I. How Can Forward Guidance Affect the Economy?

Conventional monetary policy primarily influences the economy through its effects on interest rates. A change in the target federal funds rate, which was the primary focus of policy deliberations prior to 2008, shifts the expectations of future monetary policy which, in turn, affect long-term interest rates. These long-term interest rates, such as those on auto loans and mortgages, are most relevant to households' spending decisions. Through this channel, then, a reduction in the target federal funds rate is able to promote spending in the economy and thus increase price pressures for firms as they begin to use resources more intensively to meet the higher demand. When the federal funds rate is fixed at its effective lower bound, however, reductions in the target overnight interest rate can no longer be used to generate this economic stimulus. …

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