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Transitory interest-rate pegs under imperfect credibility

  • Alex Haberis

    ()

    (Bank of England)

  • Richard Harrison

    ()

    (Bank of England
    Centre for Macroeconomics (CFM))

  • Matt Waldron

    ()

    (Bank of England)

In this paper we show that the macroeconomic effects of a transient interestrate 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.

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File URL: http://www.centreformacroeconomics.ac.uk/Discussion-Papers/2014/CFMDP2014-22-Paper.pdf
File Function: First version, 2014
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Paper provided by Centre for Macroeconomics (CFM) in its series Discussion Papers with number 1422.

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Length: 42 pages
Date of creation: Jul 2014
Date of revision:
Handle: RePEc:cfm:wpaper:1422
Contact details of provider: Web page: http://www.centreformacroeconomics.ac.uk/

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  1. Ernst Schaumburg & Andrea Tambalotti, 2003. "An investigation of the gains from commitment in monetary policy," Staff Reports 171, Federal Reserve Bank of New York.
  2. Jung, Taehun & Teranishi, Yuki & Watanabe, Tsutomu, 2005. "Optimal Monetary Policy at the Zero-Interest-Rate Bound," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 37(5), pages 813-35, October.
  3. Tom Holden & Michael Paetz, 2012. "Efficient simulation of DSGE models with inequality constraints," School of Economics Discussion Papers 1612, School of Economics, University of Surrey.
  4. Burgess, Stephen & Fernandez-Corugedo, Emilio & Groth, Charlotta & Harrison, Richard & Monti, Francesca & Theodoridis, Konstantinos & Waldron, Matt, 2013. "The Bank of England's forecasting platform: COMPASS, MAPS, EASE and the suite of models," Bank of England working papers 471, Bank of England.
  5. Davide Debortoli & Ricardo Nunes, 2007. "Loose commitment," International Finance Discussion Papers 916, Board of Governors of the Federal Reserve System (U.S.).
  6. Hughes, Abigail & Saleheen, Jumana, 2012. "UK labour productivity since the onset of the crisis — an international and historical perspective," Bank of England Quarterly Bulletin, Bank of England, vol. 52(2), pages 138-146.
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