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The Forward Guidance Trap

Author

Listed:
  • Athanasios Orphanides

    (Professor of the Practice of Global Economics and Management at the MIT Sloan Schoolof Management (E-mail: athanasios.orphanides@mit.edu))

Abstract

This paper examines the policy experience of the Federal Reserve (Fed), the European Central Bank (ECB), and the Bank of Japan (BOJ) during and after the Covid-19 pandemic and draws lessons for monetary policy strategy and its communication. All three central banks provided appropriate accommodation during the pandemic but two failed to unwind this accommodation in a timely manner. The Fed and the ECB guided real interest rates to inappropriately negative levels as the economy recovered from the pandemic, fueling high inflation. The policy error can be traced to decisions regarding forward guidance on policy rates that delayed lift-off while the two central banks continued to expand their balance sheets. The Fed and the ECB fell into the forward guidance trap. This could have been avoided if policy were guided by a forward-looking rule that properly adjusted the nominal interest rate with the evolution of the inflation outlook.

Suggested Citation

  • Athanasios Orphanides, 2024. "The Forward Guidance Trap," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 42, pages 71-92, November.
    • Handle: RePEc:ime:imemes:v:42:y:2024:p:71-92
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    File URL: https://www.imes.boj.or.jp/research/papers/english/me42-5.pdf
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    More about this item

    Keywords

    Monetary policy strategy; Forward guidance; Policy rules;
    All these keywords.

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination

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