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The Limitations of Forward Guidance

This paper examines the economic effects of Odyssean forward guidance—a promise by the central bank to keep future policy rates lower than its policy rule suggests. We focus on the impact of forward guidance when the policy rate is at its zero lower bound (ZLB), but also show its effects when the ZLB does not bind. Our analysis is conducted using a New Keynesian model where forward guidance enters as news shocks to the monetary policy rule. Three key findings emerge: (1) Conventional monetary policy is more stimulative than forward guidance away from the ZLB; (2) If the economy is in a deep recession or households expect a slow recovery, then the stimulative effect of forward guidance is minimal because the policy rate is likely to remain at its ZLB even without forward guidance; and (3) Longer forward guidance horizons do not reverse the stimulative effect or cause it to explode, but instead spread the effect across the horizon. We then compare the predictions of our model to survey data collected before and after recent FOMC announcements. Our analysis reveals that the FOMC’s pessimism about near-term economic growth likely dampened household expectations, which limited the stimulative effect of forward guidance.

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