Forward guidance led to policy errors
The Fed and the ECB fell into the forward guidance trap after the pandemic, argues Athanasios Orphanides in this paper. Both central banks provided appropriate accommodation during the pandemic but failed to unwind this accommodation in a timely manner guiding real interest rates to inappropriately negative levels as the economy recovered. This led to high inflation. The policy error can be traced to decisions regarding forward guidance on policy rates. Orphanides highlights the importance of a forward-looking rule that properly adjusts the nominal interest rate with the evolution of the inflation outlook as a superior guide for systematic monetary policy. As can be seen from the figure below, for over a year before lift-off, as inflation rose and the inflation outlook deteriorated, both the Fed and ECB kept guiding real interest rates to lower and more negative levels.
How can we explain why the Fed fell into this trap? Two elements in the Fed’s implementation of forward guidance induced a significant delay in the policy response to an unexpected increase in inflation: First, a decision to move from forecast-based to outcome-based forward guidance; And second, an implicit commitment to a gradual reduction of net asset purchases (tapering), and to raising policy rates only after net asset purchases ended.
How did forward guidance lead the ECB into this trap? Two elements induced a significant delay in the ECB’s policy response to an unexpected increase in inflation: First, a calendar-based implementation of two asset purchase programs, with a preannounced schedule of net purchases (over a year, on some occasions). Second, a commitment to raising policy rates only after net asset purchases ended—a “sequencing” restriction that was an important component of the ECB’s forward guidance.
The Forward Guidance Trap
Author: Athanasios Orphanides
From: MIT
