By Marcus Hagedorn, Iourii Manovskii, Jinfeng Luo and Kurt Mitman
We assess the power of forward guidance—promises about future interest rates—as a monetary tool in a liquidity trap using a quantitative incomplete-markets model. Our results suggest the effects of forward guidance are negligible. A commitment to keep future nominal interest rates low for a few quarters—although macro indicators suggest otherwise—has only trivial effects on current output and employment. We explain theoretically why in complete markets models forward guidance is powerful—generating a “forward guidance puzzle”—and why this puzzle disappears in our model. We also clarify theoretically ambiguous conclusions from previous research about the effectiveness of forward guidance in incomplete and complete markets models.
How forward guidance works (or does not work) has an aura of mystery, in large part because it is difficult to formalize the commitment and its impact. This paper makes a serious attempt at it and shows it does not work too well, at least in this model. My suspicion why forward guidance is so popular among policy makers is that they bank on herding behavior and hope to be the lead. Formalizing that and justifying the microfoundations is hard.