Learning and the Effectiveness of Central Bank Forward Guidance

• Date: 01 February 2021
• Author: STEPHEN J. COLE
• DOI: http://doi.org/10.1111/jmcb.12696
• Published date: 01 February 2021

DOI: 10.1111/jmcb.12696

STEPHEN J. COLE

Learning and the Effectiveness of Central Bank

Forward Guidance

This paper examines the link between expectations formation and the ef-

fectiveness of central bank forward guidance. A standard New Keynesian

model is extended to include forward guidance shocks in the monetary pol-

icy rule. Agents form expectations about future macro-economic variables

via either the standard rational expectations hypothesis or an adaptive learn-

ing model. The results show that the assumption of rational expectations

overstates the effects of forward guidance relativeto adaptive learning dur-

ing an economic crisis. Thus, if monetary policy is based on a model with

rational expectations, the results of forward guidance could be potentially

misleading.

JEL codes: D84, E30, E50, E52, E58, E60

Keywords: forward guidance, monetary policy, adaptivelearning,

expectations

O U.S. -   effectivelyreached

the zero lower bound (ZLB) during the 2007–09 global nancial crisis, monetary

policymakers exhausted the conventional policytool as overnight interest rates could

not be lowered. In response, central banks pursued “unconventional” policies. One

of these alternatives pursued by the Federal Reserve was large-scale asset purchases

where the central bank purchases longer term securities in hopes of lowering long-

term yields. Another unconventional policy was forward guidance, where the central

bank communicates to the public information about the future course of the policy

rate. Forward guidance has been pursued by central banks such as the Federal Re-

serve, Bank of Canada, Bank of England, and the European Central Bank. An exam-

ple of forward guidance was given in the September 2012 Federal Open Market Com-

mittee (FOMC) statement: “the Committee also … anticipates that exceptionally low

I would like to thank the journal editor Pok-sang Lam, an anonymous referee, Fabio Milani, William

Branch, and Eric Swanson for their helpful comments that substantially improved the paper.

An earlier version of the paper was titled “Forward Guidance, Expectations, and Learning.”

S J. C is an assistant professor,Department of Economics, Marquette University (E-mail:

stephen.cole@marquette.edu).

Received September 14, 2015; and accepted in revised form September 23, 2019.

Journal of Money, Credit and Banking, Vol. 53, No. 1 (February 2021)

© 2020 The Ohio State University

158 :MONEY,CREDIT AND BANKING

levels for the federal funds rate are likely to be warranted at least through mid-

2015” (Federal Reserve 2012). In addition, Eggertsson and Woodford (2003) and

Woodford (2012) argue that committing to an interest rate path that is lower than

what one would commit to under normal circumstances (i.e., when overnight inter-

est rates are away from the ZLB) can have additional stimulative economic effects.

Standard New Keynesian models (e.g., Woodford 2003) predict consumption, invest-

ment, and pricing decisions are sensitive to the expected path of short term inter-

est rates. If agents expect low interest rates in the future, current consumption and

prices all increase. This stimulative effect can be limited by a conventional mone-

tary policy rule that adjusts interest rates in response to target variables, such as the

output gap and ination. Households and rms may rationally expect higher inter-

est rates in response to future expansions. If a forward guidance statement, instead,

keeps a low policy rate through part of the expansion, consumption today will not be

as limited.

The effectiveness of forward guidance hinges on how private sector expecta-

tions about economic state variables (e.g., output and ination) and interest rates

respond to forward guidance. Therefore, it is important to study whether the eco-

nomic effects of forward guidance are sensitive to the rational expectations as-

sumption that is the standard benchmark in macro-economic models.1While a

reasonable benchmark that is popular among macro-economic models, rational

expectations makes strong assumptions about the amount of knowledge agents

possess when forming beliefs. It is natural then to examine how effective for-

ward guidance policies can be under a more plausible theory of expectations

formation.

This paper studies the effectiveness of forward guidance in an environment where

rational expectations have been replaced by an adaptive learning rule similar to one

proposed by Marcet and Sargent (1989) and Evans and Honkapohja (2001). In par-

ticular, the economic environment is based on Preston (2005), who derives a New

Keynesian model with (potentially) nonrational expectations. Households and rms

formulate spending and pricing decisions, respectively, that depend on their subjec-

tive expectations about future economic conditions and interest rates. The novelty

of this paper is to incorporate policy communication about future interest rates into

agents’ subjective expectations. The central bank sets interest rates according to a

monetary policy rule that responds positively to the output gap and ination. The

rule is augmented with anticipated shocks as in Del Negro, Giannoni, and Patterson

(2012) and Laséen and Svensson (2011).2The anticipated shocks dene central bank

communication about future deviations from a normal interest rate rule that agents

know today. The shocks also represent time-contingent forward guidance in which

the central bank communicates a denitive forward guidance end date. In this case,

1. A related issue is the credibility of policymakers to commit to a future path of interest rates (see,

for instance, Woodford 2012). In part, because of credibility concerns, Woodford(2012) prefers forward

guidance policies that explicitly state the criteria that will underlie future policy rules. This current paper

abstracts from this subject.

2. The anticipated shocks are similar to the news shocks of Schmitt-Grohé and Uribe (2012).

STEPHEN J. COLE :159

communication about the future path of interest rates is for a xed amount of periods

into the future and is independent of economic conditions.3

Agents are assumed to form expectations via either the rational expectations hy-

pothesis or an adaptive learning rule. The former is a strong assumption and assumes

agents construct expectations with respect to the true probability distribution of the

model. Rational expectations agents must know the model’s deep parameters, struc-

ture of the model, beliefs of other agents, and distribution of the error terms. A popu-

lar alternative to rational expectations is adaptivelearning. This approach builds from

the cognitive consistency principle that agents behaveas real-life economists (see, for

instance, Evans and Honkapohja 2013). An econometrician, for example, would pro-

duce forecasts of future economic variables by forming an econometric model. He or

she would estimate the parameters using standard econometric techniques. As new

data arrive, these forecasts would be revised. Thus, a real-life economist is engaging

in a process of learning about the economy. Analogously,adaptive learning agents are

assumed to behave as econometricians and formulate forecasts of future endogenous

variables using standard econometric techniques. The variables in their econometric

model are based on the solution found under rational expectations, but adaptive learn-

ing agents estimate the parameters using ordinary least squares. Their beliefs about

future endogenous variables are appropriately revised as new data arrive.4

The results of this paper show that the desired effect of forward guidance depends

on the manner in which agents form their expectations. This outcome is rst shown

during normal economic times.5The impulse responses of the endogenous variables

under adaptive learning fail to capture the precise effects a forward guidance shock

has on the economy. There exists more persistence in the paths of the output gap

and ination under adaptive learning than rational expectations. Differences also oc-

cur when the central bank communicates to both rational expectations and adaptive

learning agents the same forward guidance information such that the interest rate will

equal 0 for an extended period of time. The output gap and ination return to long-run

equilibrium quicker under rational expectations than adaptive learning. Under adap-

tive learning, the paths of the output gap and ination overshoot and undershoot the

rational expectations paths. Consequently, there exists larger variation of the paths

of the output gap and ination under adaptive learning than rational expectations.

These effects occur because rational expectations agents fully understand the precise

and positive effects of forward guidance on the economy. However,adaptive learning

agents fail to understand the positive effects and must continually make adjustments

to their beliefs causing them to overshoot and undershoot the rational expectations

paths of the output gap and ination.

3. This type of forward guidance is in contrast to state-contingent forward guidance where the duration

of a constant interest rate path is linked to economic conditions.

4. Adaptive learning agents do not take into account they will update their beliefs in future periods.

They believe that the beliefs they form every period are optimal. This methodology follows from the

anticipated utility discussion from Kreps (1998).

5. As will be discussed in Section 3, forward guidance is assumed to start after a large number of

periods have passed, that is, after a period of economic stability.