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posted on 14 September 2015

Has Forward Guidance Been Effective?

from the Kansas Fed

-- this post authored by A. Lee Smith and Thealexa Becker

Since 2008, the Federal Reserve has relied on unconventional policy measures to fulfill its dual mandate. These unconventional tools became necessary when the effective lower bound on nominal rates prevented further cuts in the target federal funds rate. One such tool used in the aftermath of the Great Recession has been forward guidance, which is communication about the future path of policy rates. But has forward guidance, as recently practiced by the Federal Open Market Committee (FOMC), been effective?

Economists have yet to reach a consensus on whether forward guidance is an effective substitute for changes in the target federal funds rate. Forward guidance is similar to conventional policy in that it provides information about short-term interest rates which affect broader interest rates that influence spending by consumers and businesses. However, forward guidance differs from conventional policy in that it carries a greater risk of being misinterpreted (Woodford). Statements that extend the duration of exceptionally low rates may be perceived as a revised forecast of a bleaker economic outlook. Consequently, forward guidance may actually reduce economic sentiment and, in turn, lower aggregate demand.

This article shows that forward guidance, as practiced by the FOMC since 2008, has had similar effects on the economy as past changes in the target federal funds rate. Policy guidance signaling that the federal funds rate would remain lower in the future than previously expected has led to increases in employment and prices. Moreover, the peak effects on employment and prices following a typical forward guidance announcement are quantitatively similar to those that followed a typical change in the effective federal funds rate before the zero lower bound became a binding constraint on conventional policy.

[click on image below to continue reading]

Source econrev/econrevarchive/2015/3q15smithbecker.pdf

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