The Power of Forward Guidance Revisited

In recent years, central banks have increasingly turned to “forward guidance” as a central tool of monetary policy, especially as interest rates around the world have hit the zero lower bound. Standard monetary models imply that far future forward guidance is extremely powerful: promises about far future interest rates have huge effects on current economic outcomes, and these effects grow with the horizon of the forward guidance. We show that the power of forward guidance is highly sensitive to the assumption of complete markets. If agents face uninsurable income risk and borrowing constraints, a precautionary savings effect tempers their responses to changes in future interest rates. As a consequence, forward guidance has substantially less power to stimulate the economy. In addition, we show that the business cycle dynamics of our incomplete markets model differ substantially from its complete market counterpart. This contrasts with the well-known results of Krusell and Smith (1998). We present approximate representations that can easily be incorporated into standard business cycle models.