Working Paper No. 561
By Lena Boneva, Richard Harrison and Matt Waldron
Motivated by policies implemented by some central banks in response to the financial crisis, we use a simple New Keynesian model to study a particular form of forward guidance. We assume that the policy maker makes a state-contingent commitment to hold the policy rate at the zero lower bound (ZLB) in a way that ensures that specific macroeconomic variables (eg inflation) do not breach particular ‘thresholds’. In common with other similar policies, threshold-based forward guidance (TBFG) can be used to stimulate the economy at the ZLB via a commitment to hold the policy rate lower-for-longer than would otherwise have been the case. But TBFG also acts as a hedge against the asymmetric effects of shocks. That is because if further adverse shocks arise, prolonging the recession, exit would be expected to occur later and the policy would provide additional stimulus. In contrast, if positive shocks arrive, so that the economy recovers more quickly than originally expected, exit would be expected to occur sooner, thereby removing some of the policy stimulus. This hedging property of TBFG also means that there is a relatively low incentive for policy makers to renege on the policy, unlike lower-for-longer policies that depend purely on calendar time.