Working Paper: NBER ID: w27748
Authors: Andrew T. Levin; Arunima Sinha
Abstract: We examine the effectiveness of forward guidance at the effective lower bound (ELB) in the context of the COVID-19 pandemic. Survey evidence underscores the myopia of professional forecasters at the initial stages of the pandemic and the extraordinary dispersion of their recent forecasts. Moreover, financial markets are now practically certain that U.S. short-term nominal interest rates will remain at the ELB for the next several years; consequently, forward guidance would have to refer to a much longer time horizon than in previous experience. To analyze the effects of these issues, we consider a canonical New-Keynesian model with three modifications: (1) expectations formation incorporates the mechanisms that have been proposed for addressing the forward guidance puzzle; (2) the central bank has imperfect credibility in making longer-horizon commitments regarding the path of monetary policy; and (3) the central bank may not have full knowledge of the true structure of the economy. In this framework, providing substantial near-term monetary stimulus hinges on making promises of relatively extreme overshooting of output and inflation in subsequent years, and hence forward guidance has only tenuous net benefits and may even be counterproductive.
Keywords: No keywords provided
JEL Codes: E52; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| myopia of professional forecasters (F37) | effectiveness of forward guidance (E60) |
| extraordinary dispersion of forecasts (G17) | effectiveness of forward guidance (E60) |
| anticipated duration of low rates (E43) | effectiveness of forward guidance (E60) |
| credibility of central bank's commitments (E58) | macroeconomic stability (E60) |
| lack of credible commitments (D86) | adverse effects on inflation and output (E31) |
| nature of forward guidance (E60) | market expectations (D84) |
| forward guidance reinforces pessimism (E66) | effectiveness of forward guidance (E60) |