Threshold-Based Forward Guidance: Hedging the Zero Bound

39 Pages Posted: 9 Jan 2017

See all articles by Lena Boneva

Lena Boneva

Bank of England

Richard Harrison

Bank of England - Monetary Analysis

Matthew Waldron

Bank of England

Date Written: January 2017

Abstract

"Threshold-based forward guidance" (TBFG) is a state-contingent commitment to hold the policy rate at the zero lower bound until macroeconomic variables breach particular "thresholds". Though such guidance has been implemented in practice, little is known about how this policy works in theory. This paper fills that gap by studying threshold-based guidance as a tool to improve outcomes at the zero bound within a general equilibrium framework. Policymakers have rarely advocated using TBFG to provide stimulus, in part reflecting skepticism about their ability to commit credibly to time inconsistent behavior. We show that TBFG can be used to provide temporary stimulus, while also limiting the time inconsistency of policy promises. We also show that existence of a unique equilibrium requires the policymaker to specify how the thresholds should be interpreted, as well as their values. The optimal design of the threshold conditions depends on the relative importance of those shocks that induce a trade-off between stabilizing output and inflation and those that do not. With an appropriate choice of thresholds, TBFG outperforms forward guidance based purely on calendar time and comes close to mimicking outcomes under optimal commitment policy.

Keywords: forward guidance, monetary policy, thresholds, zero lower bound

JEL Classification: E17, E31, E52

Suggested Citation

Boneva, Lena and Harrison, Richard and Waldron, Matthew, Threshold-Based Forward Guidance: Hedging the Zero Bound (January 2017). CEPR Discussion Paper No. DP11749, Available at SSRN: https://ssrn.com/abstract=2896039

Lena Boneva (Contact Author)

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Richard Harrison

Bank of England - Monetary Analysis ( email )

Threadneedle Street
London EC2R 8AH
United Kingdom

Matthew Waldron

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

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