The paper “The MacroeconomicEffect of Federal Reserve Forward Guidance: Analysis Based on DSGE Model”, co-authoredby Professor XiaofenTAN, Associate Dean of School of Finance at CUFE, Yaying GENG and HuilunXU, Ph.D. candidates of School of Finance, was published in “Studies ofInternational Finance”, the 5th issueof 2019.
TheMacroeconomic Effect of Federal Reserve Forward Guidance:
AnalysisBased on DSGE Model
Forwardguidance is the central bank communicating with the public on the future trendof the policy interest rate, and managing the market's expectation of futurepolicies. At present, there is no zero lower bound in China. Thus the People'sBank of China (PBC) has not formally proposed to implement the forward guidanceso far, but this does not mean that forward guidance is not worth learning.Forward guidance is an important way for central bank communication andexpectation management (Carney, 2013). Under the revolution of rationalexpectation, central banks have realized the importance of policy communicationand transparency in improving the effectiveness of monetary policy (Blinder etal., 2008). Currently, China's monetary policy is transforming fromquantity-oriented to price-oriented, facing the predicament that theeffectiveness of quantity-oriented monetary policy declines while price-orientedmonetary policy is incomplete, which leads to the inevitable decline of theeffectiveness of monetary policy(Guo et al., 2016). Thus more attention shouldbe paid to the communication between the central bank and the market in orderto strengthen the regulating capacity of monetary policy. In view of this,exploring the forward guidance is of great theoretical and practicalsignificance for strengthening the monetary policy communication and improvingthe effectiveness of monetary policy.
Atpresent, foreign scholars have made deep exploration of forward guidance, whileresearch on forward guidance is relatively new in China. In order to enrich theresearch in this field, based on Smets & Wouters (2007), this paperestablishes a new Keynesian DSGE model to examine the effect of forwardguidance. This model is different from Smets & Wouters (2007) in two ways.First, following Laseen& Svensson (2011) and Del Negro et al. (2012), weintroduce anticipated policy shock into the monetary policy rule to captureforward guidance. Second, considering the changing characteristics of centralbank inflation target from 1993Q1to 2018Q1, we follow Campbell et al. (2012,2016) and introduce inflation target shock into the monetary policy rule.Besides, the federal funds rate hit the effective lower bound after 2008Q3, sofollowing Campbell et al. (2012, 2016) and Del Negro et al. (2013), we take2008Q3 as a structural breakpoint, use Bayesian method to estimate theparameters with U.S. data in two steps and use the variance decomposition andimpulse response to analyze the macroeconomic effect of forward guidance.
Themain findings of this paper can be summarized as follows. First, in thesubsample from 2008Q4 to2018Q1, forward guidance can explain 15% to 45% offluctuations in output, consumption, investment, labor and interest rate.Meanwhile, the effect of conventional monetary policy is also significant.Second, during normal economic period, through guiding public inflationexpectation, forward guidance can change the current consumption and investmentdecision, which makes the economy respond to policy adjustments in advance.Besides, there is no significant forward guidance puzzle in the results. Third,the degree of price stickiness and the policy response coefficients ofinflation gap and output gap can affect the macroeconomic effect of forwardguidance. The larger the stickiness and the smaller the coefficients, thestronger the effect. Fourth, during the economic downturn, conventionalmonetary policy is constrained by the zero lower bound. The central bankannounces that it will keep the interest rate at the zero lower bound until theend of recession. This forward guidance can not only alleviate economicrecession, but also promote economic recovery.
Theresults show that forward guidance, as an advanced tool of central bankcommunication policy, can effectively guide the market expectation. Currently,China's economy has entered a new normal, which requires monetary policy toadapt to and lead. In order to improve the effectiveness of monetary policy,PBC should learn from the successful experience of developed countries' centralbanks, and explore forward guidance tools suitable for China. Furthermore, PBCshould strengthen the communication with the market, enrich the content of thecommunication, and pay attention to the transparency and timeliness of thecommunication.