Learning and the effectiveness of central bank forward guidance

Cole, Stephen (2015): Learning and the effectiveness of central bank forward guidance.

Abstract

The unconventional monetary policy of forward guidance operates through the management of expectations about future paths of interest rates. This paper examines the link between expectations formation and the effectiveness of forward guidance. A standard New Keynesian model is extended to include forward guidance shocks in the monetary policy rule. Agents form expectations about future macroeconomic variables via either the standard rational expectations hypothesis or a more plausible theory of expectations formation called adaptive learning. The results show the efficacy of forward guidance depends on the manner in which agents form their expectations. In response to forward guidance, the paths of the output gap and inflation under adaptive learning overshoot and undershoot those implied by rational expectations. The adaptive learning impulse responses of the endogenous variables to a forward guidance shock exhibit more persistence before and after the forward guidance shock has been realized upon the economy. During an economic crisis (e.g. a recession), the assumption of rational expectations overstates the effects of forward guidance relative to adaptive learning. Specifically, the output gap is higher under rational expectations than adaptive learning. Thus, if monetary policy is based on a model with rational expectations, which is the standard assumption in the macroeconomic literature, the results of forward guidance could be potentially misleading.

• Item Type: MPRA Paper
• Language: English
• Keywords: Forward Guidance; Monetary Policy; Adaptive Learning; Expectations
• Subjects: D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D84 - Expectations ; Speculations; E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles > E30 - General; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E50 - General; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E52 - Monetary Policy; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E58 - Central Banks and Their Policies; E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook > E60 - General

References

Baker, S. R., Bloom, N., and Davis, S. J. (2013). Measuring economic policy uncertainty. Chicago Booth research paper, (13-02).

Branch, W. A. (2004). The theory of rationally heterogeneous expectations: evidence from survey data on inflation expectations. The Economic Journal, 114(497):592{621.

Branch, W. A. and Evans, G. W. (2006). A simple recursive forecasting model. Economics Letters, 91(2):158{166.

Branch, W. A. and Evans, G. W. (2013). Unstable inflation targets. mimeo.

Branch, W. A. and McGough, B. (2009). A new keynesian model with heterogeneous expectations. Journal of Economic Dynamics and Control, 33(5):1036-1051.

Calvo, G. (1983). Staggered prices in a utility-maximizing framework. Journal of Monetary Economics, 12(3):383-398.

Carlstrom, C., Fuerst, T., and Paustian, M. (2012). Inflation and output in new keynesian models with a transient interest rate peg (Working Paper No. 459). Retrieved from: http://www.bankofengland.co.uk/research/documents/workingpapers/2012/wp459.pdf.

Chang, B. Y. and Feunou, B. (2013). Measuring uncertainty in monetary policy using implied volatility and realized volatility (Working Paper No. 2013-37). Retrieved from: http://www.bankofcanada.ca/wp-content/uploads/2013/10/wp2013-37.pdf.

Committee, M. P. et al. (2013). Monetary policy trade-offs and forward guidance. Bank of England.

De Graeve, F., Ilbas, P., and Wouters, R. (2014). Forward guidance and long term interest rates: inspecting the mechanism. Sveriges Riksbank Working Paper Series, (292).

Del Negro, M., Giannoni, M., and Patterson, C. (2012). The forward guidance puzzle. FRB of New York Staff Report, (574).

Eggertsson, G. B. (2008). Great expectations and the end of the depression. The American Economic Review, 98(4):1476-1516.

Eggertsson, G. B. and Woodford, M. (2003). The zero bound on interest rates and optimal monetary policy. Brookings Papers on Economic Activity, (1):139-211.

Eusepi, S. and Preston, B. (2010). Central bank communication and expectations stabilization. American Economic Journal: Macroeconomics, 2(3):235-271.

Eusepi, S. and Preston, B. (2011). Expectations, learning, and business cycle fluctuations. American Economic Review, 101(6):2844-72.

Evans, G. W. and Honkapohja, S. (2001). Learning and expectations in macroeconomics. Princeton University Press.

Evans, G. W. and Honkapohja, S. (2013). Learning as a rational foundation for macroeconomics and finance. Rethinking Expectations: The Way Forward for Macroeconomics, 68.

Evans, G. W., Honkapohja, S., and Mitra, K. (2009). Anticipated fiscal policy and adaptive learning. Journal of Monetary Economics, 56(7):930-953.

Evans, G. W., Honkapohja, S., and Mitra, K. (2013). Notes on agents' behavioral rules under adaptive learning and studies of monetary policy. Macroeconomics at the Service of Public Policy, page 63.

Femia, K., Friedman, S., and Sack, B. P. (2013). The effects of policy guidance on perceptions of the fed's reaction function. FRB of New York Staff Report, (652).

Gertler, M. and Karadi, P. (2011). A model of unconventional monetary policy. Journal of Monetary Economics, 58(1):17-34.

Giannoni, M. and Woodford, M. (2004). Optimal inflation-targeting rules. In The Inflation-Targeting Debate, pages 93-172. University of Chicago Press.

Gurkaynak, R. S., Sack, B., and Swanson, E. T. (2005). Do actions speak louder than words? the response of asset prices to monetary policy actions and statements. International Journal of Central Banking.

Honkapohja, S. and Mitra, K. (2005). Performance of inflation targeting based on constant interest rate projections. Journal of Economic Dynamics and Control, 29(11):1867-1892.

Klenow, P. J. and Malin, B. A. (2010). Microeconomic evidence on price-setting. Handbook of Monetary Economics, 3:231-284.

Kreps, D. M. (1998). Anticipated utility and dynamic choice. In Jacobs, D. P., Kalai, E., and Kamien, M. I., editors, Frontiers of Research in Economic Theory: The Nancy L. Schwartz Memorial Lectures, pages 242{274. Cambridge University Press.

Laseen, S. and Svensson, L. E. (2011). Anticipated alternative policy rate paths in policy simulations. International Journal of Central Banking.

Levin, A., Lopez-Salido, D., Nelson, E., and Yun, T. (2010). Limitations on the effectiveness of forward guidance at the zero lower bound. International Journal of Central Banking.

Marcet, A. and Nicolini, J. P. (2003). Recurrent hyperinflations and learning. The American Economic Review, 93(5):1476-1498.

Marcet, A. and Sargent, T. J. (1989). Convergence of least squares learning mechanisms in self-referential linear stochastic models. Journal of Economic Theory, 48(2):337-368.

McKay, A., Nakamura, E., and Steinsson, J. (2015). The power of forward guidance revisited. Technical report, National Bureau of Economic Research.

Milani, F. (2007). Expectations, learning and macroeconomic persistence. Journal of Monetary Economics, 54(7):2065-2082.

Milani, F. (2014). Learning and time-varying macroeconomic volatility. Journal of Economic Dynamics and Control, 47:94-114.

Milani, F. and Treadwell, J. (2012). The effects of monetary policy news and surprises. Journal of Money, Credit and Banking, 44(8):1667-1692.

Mitra, K., Evans, G. W., and Honkapohja, S. (2012). Fiscal policy and learning. Bank of Finland Research Discussion Paper, (5).

Orphanides, A. and Williams, J. C. (2005). The decline of activist stabilization policy: natural rate misperceptions, learning, and expectations. Journal of Economic Dynamics and Control, 29(11):1927-1950.

Preston, B. (2005). Learning about monetary policy rules when long-horizon expectations matter. International Journal of Central Banking, 1(2):81-126.

Preston, B. (2006). Adaptive learning, forecast-based instrument rules and monetary policy. Journal of Monetary Economics, 53(3):507-535.

Schmitt-Grohe, S. and Uribe, M. (2012). What's news in business cycles. Econometrica, 80(6):2733-2764.

Sims, C. A. (2002). Solving linear rational expectations models. Computational Economics, 20(1):1-20.

Smets, F. and Wouters, R. (2003). An estimated dynamic stochastic general equilibrium model of the euro area. Journal of the European Economic Association, 1(5):1123-1175.

Swanson, E. T. and Williams, J. C. (2014). Measuring the effect of the zero lower bound on medium-and longer-term interest rates. American Economic Review, 104(10):3154-3185.

Woodford, M. (2003). Interest and prices: foundations of a theory of monetary policy. princeton university press.

Woodford, M. (2005). Central bank communication and policy effectiveness. In The Greenspan Era: Lessons for the Future, pages 399-474. Federal Reserve Bank of St. Louis.

Woodford, M. (2012). Methods of policy accommodation at the interest-rate lower bound. In The Changing Policy Landscape: 2012 Jackson Hole Symposium. Federal Reserve Bank of Kansas City.