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Transitory interest-rate pegs under imperfect credibility

Alex Haberis (), Richard Harrison () and Matt Waldron ()

No 1422, Discussion Papers from Centre for Macroeconomics (CFM)

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.

Keywords: New Keynesian Model; Monetary Policy; Zero Lower Bound (search for similar items in EconPapers)
JEL-codes: E12 E17 E20 E30 E42 E52 (search for similar items in EconPapers)
Pages: 42 pages
Date: 2014-07
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
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Citations: View citations in EconPapers (9) Track citations by RSS feed

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