Monetary Policy and Trend-Following Behavior: The Impact of the Expectations Channel under Moderate Rules and Low Interest Rates

Abstract

We reexamine the impact of interest rate policy on expectation formation by incorporating a more realistic interest rate adjustment rule into the learning-to-forecast experimental framework. Our results show that interest rate policy reduces participants' tendency to follow price trends and significantly suppresses asset price bubbles. Moreover, this stabilizing effect remains even with moderate interest rate adjustments. An additional treatment conducted under a low base interest rate shows that the policy is more effective in such conditions than in a high-interest rate environment. Finally, simulations disentangle the two channels through which interest rate policy may suppress bubbles---the discount rate channel and the expectations channel. The impact of these channels is nearly the same under aggressive monetary policy rules; however, under moderate policy rules, the expectations channel is stronger than the discount rate channel.

Keywords: monetary policy, asset price bubbles, asset price forecasting experiments, trendfollowing expectations