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Transitory interest-rate pegs under imperfect credibility

Author

Listed:
  • Alex Haberis

    (Bank of England)

  • Richard Harrison

    (Bank of England
    Centre for Macroeconomics (CFM))

  • Matt Waldron

    (Bank of England)

Abstract
In this paper we show that the macroeconomic effects of a transient interest rate peg can be significantly dampened when the peg is perceived to be imperfectly credible by the private sector. By doing so, we provide a solution to what has become known as the "forward guidance puzzle". This is the finding that pegging nominal interest rates to a specific value or path for an extended, yet finite, period of time in New Keynesian models generates macroeconomic responses that are implausibly large. This puzzle has been of interest because several central banks have implemented "forward guidance" which has been interpreted by some as a promise to hold the policy rate lower than had been previously expected: a so-called lower-for-longer (LFL) policy. The New Keynesian models that these central banks routinely use for policy analysis would predict that LFL policies generate very large effects. The possibility that LFL policies might be imperfectly credible arises from their potential to be time inconsistent. Indeed, using an ad-hoc loss function for the central bank we show that it may have an incentive to renounce the LFL policy along the full commitment path. We examine cases in which the degree of imperfect credibility is exogenous and in which it is endogenously related to the state of the economy via the policymaker's incentive to renounce. Allowing for endogenous imperfect credibility tends to dampen the response of macroeconomic variables to an LFL policy announcement by more than under exogenous imperfect credibility.

Suggested Citation

  • Alex Haberis & Richard Harrison & Matt Waldron, 2014. "Transitory interest-rate pegs under imperfect credibility," Discussion Papers 1422, Centre for Macroeconomics (CFM).
    • Handle: RePEc:cfm:wpaper:1422
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    References listed on IDEAS

    as
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    Cited by:

    1. Fabio Canetg, 2021. "Strategic deviations in optimal monetary policy," Swiss Journal of Economics and Statistics, Springer;Swiss Society of Economics and Statistics, vol. 157(1), pages 1-13, December.
    2. William T. Gavin & Benjamin D. Keen & Alexander W. Richter & Nathaniel A. Throckmorton, 2013. "The stimulative effect of forward guidance," Working Papers 2013-38, Federal Reserve Bank of St. Louis.
    3. Fabio Canetg, 2018. "Strategic Deviations in Optimal Monetary Policy," Diskussionsschriften dp1817, Universitaet Bern, Departement Volkswirtschaft.
    4. Boneva, Lena & Harrison, Richard & Waldron, Matt, 2015. "Threshold-based forward guidance: hedging the zero bound," Bank of England working papers 561, Bank of England.
    5. Cole, Stephen J. & Martínez-García, Enrique, 2023. "The effect of central bank credibility on forward guidance in an estimated New Keynesian model," Macroeconomic Dynamics, Cambridge University Press, vol. 27(2), pages 532-570, March.
    6. Jeffrey Campbell & Jacob Weber, 2021. "Discretion rather than rules: Equilibrium uniqueness and forward guidance with inconsistent optimal plans," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 41, pages 243-254, July.
    7. Müller, Tobias & Christoffel, Kai & Mazelis, Falk & Montes-Galdón, Carlos, 2022. "Disciplining expectations and the forward guidance puzzle," Journal of Economic Dynamics and Control, Elsevier, vol. 137(C).
    8. Benjamin D. Keen & Alexander W. Richter & Nathaniel A. Throckmorton, 2017. "Forward Guidance And The State Of The Economy," Economic Inquiry, Western Economic Association International, vol. 55(4), pages 1593-1624, October.
    9. Gunda‐Alexandra Detmers & Ozer Karagedikli & Richhild Moessner, 2021. "Quantitative or Qualitative Forward Guidance: Does it Matter?," The Economic Record, The Economic Society of Australia, vol. 97(319), pages 491-503, December.
    10. Richhild Moessner & David-Jan Jansen & Jakob de Haan, 2017. "Communication About Future Policy Rates In Theory And Practice: A Survey," Journal of Economic Surveys, Wiley Blackwell, vol. 31(3), pages 678-711, July.
    11. Harrison, Richard, 2015. "Estimating the effects of forward guidance in rational expectations models," European Economic Review, Elsevier, vol. 79(C), pages 196-213.
    12. Tolga Özden, 2021. "Heterogeneous Expectations and the Business Cycle at the Effective Lower Bound," Working Papers 714, DNB.
    13. Moessner, Richhild, 2015. "Reactions of US government bond yields to explicit FOMC forward guidance," The North American Journal of Economics and Finance, Elsevier, vol. 33(C), pages 217-233.
    14. Goy, Gavin & Hommes, Cars & Mavromatis, Kostas, 2022. "Forward guidance and the role of central bank credibility under heterogeneous beliefs," Journal of Economic Behavior & Organization, Elsevier, vol. 200(C), pages 1240-1274.
    15. Richhild Moessner & David-Jan Jansen & Jakob de Haan, 2017. "Communication About Future Policy Rates In Theory And Practice: A Survey," Journal of Economic Surveys, Wiley Blackwell, vol. 31(3), pages 678-711, July.
    16. Gavin Goy & Cars Homme & Kostas Mavromatis, 2018. "Forward Guidance and the Role of Central Bank Credibility," DNB Working Papers 614, Netherlands Central Bank, Research Department.

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    More about this item

    Keywords

    New Keynesian Model; Monetary Policy; Zero Lower Bound;
    All these keywords.

    JEL classification:

    • E12 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Keynes; Keynesian; Post-Keynesian; Modern Monetary Theory
    • E17 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Forecasting and Simulation: Models and Applications
    • E20 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - General (includes Measurement and Data)
    • E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)
    • E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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