Blog post

The forward guidance paradox

What’s at stake: the term “forward guidance” is used in economic jargon to describe central bank communications about the likely future path of policy

Publishing date
10 July 2017
Silvia Merler

Negro, Giannoni and Patterson empirically document the impact of forward guidance announcements on a broad cross section of financial markets data and professional forecasts. They find that Federal Open Market Committee (FOMC) announcements containing forward guidance had heterogeneous effects depending on the other content of the statement and show that once these other elements are controlled for, forward guidance had on average a positive and meaningful effect on output and inflation expectations. Using this benchmark, they also show that standard medium-scale DSGE models tend to grossly overestimate the impact of forward guidance on the macroeconomy. They call this phenomenon a “forward guidance puzzle”, and argue that the incorporation a perpetual youth structure into the benchmark allows for a solution.

Kiley argues that the common sticky-prices New-Keynesian model behaves differently in a zero-lower bound environment. Not only fiscal, but also forward guidance multipliers can be very large. Positive supply shocks, such as an increase in productivity, will lower production, and increased price flexibility can exacerbate such a decline in output (as well as amplifying the effects of other shocks). He finds that these results are fragile and disappear under a plausible alternative to sticky prices (sticky information): fiscal and monetary multipliers are smaller, positive supply shocks raise output, and greater price flexibility, in the sense of more frequent updating of information, moves the economy's response toward the neoclassical benchmark.

Di Bartolomeo, Beqiraj, and Di Pietro study the extent to which the belief-formation process affects the dynamics of macroeconomic variables when the central bank uses forward guidance. Standard sticky-price models imply that far future forward guidance has huge and implausible effects on current outcomes, which grow its horizon (forward guidance power puzzle). By a parsimonious macro-model that allows for the role of bounded rationality and heterogeneous agents, they obtain tempered responses for real and nominal variables.

McKay, Nakamura and Steinsson also investigate why standard monetary models imply that far future forward guidance has huge effects on current outcomes, and these effects grow with the horizon of the forward guidance. They offer a model in which the power of forward guidance is highly sensitive to the assumption of complete markets. When agents face uninsurable income risk and borrowing constraints, a precautionary savings effect tempers their responses to changes in future interest rates. As a consequence, forward guidance has substantially less power to stimulate the economy.

Nakata highlights the potential time-inconsistency of forward guidance, and proposes reputation as a way to solve the inconsistency constraint. Nakata’s model combines a theory of reputation from game theory literature with a standard sticky-price macroeconomic model. If the central bank reneges on its promise to keep the policy rate low for an extended period, it can eliminate overshooting of inflation and output in the short run but it loses its reputation and the private sector will not believe similar promises in future recessions. Instead, the private sector believes that the central bank will follow the discretionary policy, and the central bank loses its ability to conduct the commitment policy. As discretionary policy would entail worse outcomes for inflation and the output gap than the commitment policy, a concern for reputation creates an incentive for the central bank to fulfill its promise. The commitment policy, however, is credible only if the crisis probability is sufficiently high.

Haberis, Harrison and Waldron at the Bank of England explore the effects of forward guidance at the zero lower bound when there is uncertainty over the lift-off date arising from: (i) the imperfect credibility of time-inconsistent forward-guidance promises and (ii) incomplete communication. Using a New Keynesian model they demonstrate that a forward guidance announcement to delay lift-off may be no more powerful in a more interest rate sensitive economy, and that attempts to delay lift-off further may fail to generate additional stimulus if the temptation to renege on the announcement is sufficiently great. Haberis et al. also consider a counterfactual policy experiments based on the Federal Open Market Committee’s ‘threshold-based’ forward guidance, in which they link the probability of lift-off to the amount by which the announced unemployment threshold is breached, and show that a more precise articulation of the lift-off conditions requires a lower unemployment threshold in order to deliver the same amount of stimulus as a less precise one.

About the authors

  • Silvia Merler

    Silvia Merler, an Italian citizen, is the Head of ESG and Policy Research at Algebris Investments.

    She joined Bruegel as Affiliate fellow at Bruegel in August 2013. Her main research interests include international macro and financial economics, central banking and EU institutions and policy making.

    Before joining Bruegel, she worked as Economic Analyst in DG Economic and Financial Affairs of the European Commission (ECFIN). There she focused on macro-financial stability as well as financial assistance and stability mechanisms, in particular on the European Stability Mechanism (ESM), providing supportive analysis for the policy negotiations.


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