The European Central Bank (ECB) issued a working paper that discusses the implications for optimal monetary policy when rates are at (or close) to their effective lower bounds.

In these cases, central banks often turn to communication about the future path of policy rates—known as forward guidance—as an alternative means to stimulate economic activity. According to the standard sticky-price model often used in academia and central banks to analyze monetary policy, for- ward guidance is a powerful substitute for a change in the current policy rate and should be used by central banks to improve welfare when the current policy rate is constrained by the lower bound. In particular, in the standard model, the central bank finds it optimal to announce that it will keep the policy rate at the lower bound for longer than would be warranted by future output and inflation stabilization considerations alone.

An intriguing feature of this standard model is that the economic effects of forward guidance can be implausibly large. This feature—often referred to as the forward guidance puzzle—has generated concern among researchers that the standard model is of limited use for the analysis of forward guidance policies and, as a result, has also generated an interest in modifying the standard model to mitigate the implausibly large effects of forward guidance. A number of recent papers have shown that various economically sensible departures from the standard framework go a long way in attenuating the forward guidance puzzle, but they have done so under the assumption that the interest rate policy is characterized by a simple feedback rule.

The paper examines the implications of attenuating the forward guidance puzzle for the optimal design of forward guidance policy. We do so by introducing private-sector discounting—discounting of the expected future income in the Euler equation and discounting of the expected future marginal costs of production in the Phillips curve—into an otherwise standard sticky-price model and characterizing how the degree of discounting affects optimal commitment policy.

When private-sector agents discount future economic conditions more in making their decisions today, an announced cut in future interest rates becomes less effective in stimulating current economic activity. While the implication of such discounting for optimal policy depends on its degree, we find that, under a wide range of plausible degrees of discounting, it is optimal for the central bank to compensate for the reduced effect of a future rate cut by keeping the policy rate at the effective lower bound for longer than in the standard model without private-sector discounting.

Attenuating the forward guidance puzzle: implications for optimal monetary policy (PDF)