By Boris Chafwehé, Rigas Oikonomou, Romanos Priftis and Lukas Vogel
We propose a novel framework where forward guidance (FG) is endogenously determined. Our model assumes that a monetary authority solves an optimal policy problem under commitment at the zero-lower bound. FG derives from two sources: 1. from commiting to keep interest rates low at the exit of the liquidity trap, to stabilize inﬂation today. 2. From debt sustainability concerns, when the planner takes into account the consolidated budget constraint in optimization. Our model is tractable and admits an analytical solution for interest rates in which 1 and 2 show up as separate arguments that enter additively to the standard Taylor rule. In the case where optimal policy reﬂects debt sustainability concerns (satisﬁes the consolidated budget) monetary policy becomes subservient to ﬁscal policy, giving rise to more volatile inﬂation, output and interest rates. Liquidity trap (LT) episodes are longer, however, the impact of interest rate policy commitments on inﬂation and output are moderate. ’Keeping interest rates low’ for a long period, does not result in positive inﬂation rates during the LT, in contrast our model consistently predicts negative inﬂation at the onset of a LT episode. In contrast, in the absence of debt concerns, LT episodes are shorter, but the impact of commitments to keep interest rates low at the exit from the LT, on inﬂation and output is substantial. In this case monetary policy accomplishes to turn inﬂation positive at the onset of the episode, through promising higher inﬂation rates in future periods. We embed our theory into a DSGE model and estimate it with US data. Our ﬁndings suggest that FG during the Great Recession may have partly reﬂected debt sustainability concerns, but more likely policy reﬂected a strong commitment to stabilize inﬂation and the output gap. Our quantitative ﬁndings are thus broadly consistent with the view that the evolution of debt aggregates may have had an impact on monetary policy in the Great Recession, but this impact is likely to be small.
I do not think we yet a good theory of forward guidance, even less of forward guidance policy formation. This paper offers an interesting perspective in this respect. It may also offer an answer as to how forward guidance could have contributed to avoiding significant inflation despite the large increase in money supply.