The European Central Bank (ECB) published a research paper aimed at assessing the effects of forward guidance – the communication of central banks about the likely future course of their monetary policy stance – on the conduct of monetary policy.
This kind of expectations management aims at affecting inflation and aggregate demand by reducing uncertainty about future monetary policy and by steering longer-term interest rates. The workhorse New Keynesian Dynamic Stochastic General Equilibrium (DSGE) model, as widely used by researchers and policy makers, predicts that a communication to keep monetary policy low in future has substantial stimulative effects on current aggregate economic activity and inflation. Empirical experience suggests yet that basic New Keynesian models tend to overstate the effects of forward guidance. One reason for the strong effects in these models is that (announced) changes in the monetary policy rate directly affect those interest rates one-to-one, on which saving and investment decisions of the private sector are based.
The yields on highly liquid government bonds react stronger to forward guidance announcements than yields on assets that are more relevant for the private sector’s intertemporal savings and investment decisions, such as corporate bond rates. The empirical analysis is based on US financial markets data and applies a method that quantifies the surprise component of the forward guidance given in all press release statements of the US Federal Open Market Committee (FOMC) between 1990 and 2016. As the main novel contribution of our empirical analysis, we show that liquidity premia rise after accommodative monetary policy decisions and that not all interest rates react one-to-one to forward guidance.
To assess the macroeconomic implications of this observation, the basic New Keynesian model is augmented by accounting for the fact that central bank money is only supplied to the private sector against eligible assets. This leads to an endogenous time-varying liquidity premium in the model between eligible and non-eligible assets. Our model, which allows to reproduce the empirically documented responses of liquidity spreads to forward guidance, predicts that the reaction of current output and inflation does not increase with the length of the guidance period and that current responses are more than ten times smaller compared to the basic New Keynesian model. Our analysis aligns the effects of forward guidance in widely-used DSGE models with empirical evidence and helps policy makers in obtaining a broader understanding of the effects of forward guidance.