![]() Policy is set optimally under discretion – the policy rate is set to minimise welfare costs arising from (current and future) deviations of output from potential and inflation from target. We use a textbook model of the output gap, inflation, and the policy rate in which expectations about the future play a large role in households’ and firms’ decision making. To illustrate the puzzle, we draw on analysis from our recent paper (Haberis et al. Textbook New Keynesian models deliver unreasonably large macroeconomic responses to forward guidance promises, a phenomenon described as the ‘forward guidance puzzle’ by Del Negro et al. Accordingly, this column should be read as a comment on the consequences of implementing such promises in textbook monetary models, rather than as a commentary on what central banks have actually done. In our view, forward guidance announcements made by central banks to date have been the former ‘reaction function clarification’ type rather than the latter ‘promise to deviate’ type (e.g. We focus on this second ‘promise’ motivation for forward guidance. This differs from the reaction function ‘clarification’ motive because it requires the central bank to promise above-target inflation in the future, which is a promise to deviate from its usual reaction function. ![]() A second motivation is to stimulate the economy by promising to keep rates lower in future as a substitute for cuts today, which may not be possible due to a lower bound.The aim is not to stimulate the economy (though that could be a by-product), but rather to make policy more effective by guiding people’s expectations to be more consistent with the central bank’s intentions. The first is to convey information about how the central bank intends to set policy to meet its objectives (its ‘reaction function’).Why have they been doing this? It is crucial to draw a distinction between two different motivations. What is new is that, since policy rates have been stuck at or near their lower bounds, central banks have made increasing use of explicit statements about their intentions regarding future policy. Forward guidance is not new – central banks have been providing guidance for decades in the form of forecasts for inflation and GDP growth. The term ‘forward guidance’ describes central bank communications about the likely future path of policy rates.
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