“Forward Guidance And Credible Monetary Policy”

Bingbing Dong, Central University of Finance and Economics

The effectiveness of forward guidance depends crucially on the credibility of the central bank. Instead of assuming full commitment or full discretion of the central bank, this paper sheds light on the best credible forward guidance policy a central bank can offer by solving for the whole set of sustainable sequential equilibria (SSE) in a standard New Keynesian model with the occasionally binding constraint of a nominal interest rate of zero. The inflation bias resulting from eliminating price distortion under the best SSE is much smaller than the bias under full discretion. In the presence of the zero lower bound (ZLB), while the full commitment solution implies that forward guidance has a longer duration of the nominal rate at zero bound followed by a quick revert-to-normal path, the best SSE features low but non-zero rates, and even a prolonged period of higher inflation after the recession ends. To make forward guidance credible and as stimulative as possible, the adjustment of policy rates, and in particular, the rise of policy rates, should be smooth and gradual. In other words, policy normalization does not mean non-accommodation. Nonetheless, the best forward guidance under SSE can boost the recession close to those under Ramsey equilibria which are not generally implementable.