Rethinking the Power of Forward Guidance: Lessons from Japan

Mark Gertler

No 17-E-08, IMES Discussion Paper Series from Institute for Monetary and Economic Studies, Bank of Japan

Abstract: In the spring of 2013 the Bank of Japan introduced a state-of- the-art monetary policy which included among other things inflation targeting and aggressive use of forward guidance. In contrast to the predictions of conventional macroeconomic theory, these policies have had only very limited success in reflating the economy. I argue that the disconnect between the Japanese experience and existing theory can be traced to the forward guidance puzzle (FGP). As recent literature suggests, the essence of the FGP is that existing models predict implausibly strong effects of expected future interest rate changes on the economy, with the strength of the effect increasing with the expected horizon of the interest rate change. Accordingly, in this lecture I sketch a model meant to capture the challenge of reflation in Japan. As in recent literature I attempt to mute the power of forward guidance by stepping outside of rational expectations. In particular, I introduce a hybrid adaptive/rational expectations belief mechanism. Most relevant to the Japanese experience is that individuals have adaptive expectations about trend inflation, which is consistent with the evidence. As Kuroda (2016) emphasizes, for an economy without a history of inflation being anchored by a target, individuals need direct evidence that the central bank is capable of moving inflation to target.

Keywords: Forward guidance; Inflation targeting; Hybrid adaptive/rational expectations (search for similar items in EconPapers)
JEL-codes: D84 E31 E52 (search for similar items in EconPapers)
Date: 2017-10
New Economics Papers: this item is included in nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (20)

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