Monetary Policy Expectations and Economic Fluctuations at the Zero Lower Bound

Abstract

Using a panel of survey-based measures of future interest rates from the Survey of Professional Forecasters, we study the dynamic relationship between shocks to monetary policy expectations and fluctuations in economic activity and inflation. We propose a smallscale structured recursive vector autoregression (VAR) model to identify the macroeconomic effects of changes in expectations about monetary policy. Our results show that when interest rates are away from the zero-lower bound, a perception of higher future interest rates leads to a significant rise in current measures of inflation and a rise in economic activity. However, when interest rates approach zero, the effect on economic activity is the opposite, with significant but lagged decreases in economic activity following an upward revision to expected future interest rates. The impact of changes in expectations about monetary policy is robust when we control for other features of the transmission mechanism (e.g., long-term interest rates, quantitative easing, exchange rate movements and even oil price shocks). Our findings also show that monetary policy expectations contribute up to 34 percent to the variability of economic activity (and 24 percent on inflation) while policy rates are fixed at the zero-lower bound. This evidence points to the importance of managing monetary policy expectations (forward guidance) as a crucial policy tool for stimulating economic activity at the zero-lower bound.

Monetary Policy Expectations and Economic Fluctuations at the Zero Lower Bound

“…This has become an important consideration for policymakers not only due to the episode of near-zero policy rates that arose from the 2007-09 Global Financial Crisis, but also in the context of the historical downward trend in interest rates experienced over the past 40 years (see, e.g.,Hamilton et al (2016)). In an environment with low interest rates, episodes where policy rates hit the ZLB or simply become fixed at low levels for an extended period of time are likely to be more frequent as the COVID19 pandemic has poignantly reminded policymakers again.4 Supplementary materials with additional results from the estimated models are available on the web to accompany this paper (seeDoehr and Martínez-García (2021)). …”