The dotted line below, in Chart 6, seeks to get the point across. It’s the outcome of a simulation in which the monetary authority periodically publishes a plan for future interest rates. People believe the plan but the monetary authority only gets to change it intermittently. In the meantime, and no matter what crops up in the economy, it’s obliged to follow the most recently published path. The idea is to convey the flavour of what happens when the central bank is (or feels) obliged routinely to “pre-announce” a path for interest rates but can only update that path now and then. Remember that this is a model in which forward interest rates have a powerful impact on current demand and economic activity. So living with the “wrong” forward rate – one that fails to respond to incoming news – can be pretty costly. In reality the economy is almost certainly less sensitive to expected future interest rates than assumed here, and the dotted line wouldn’t be so far above the others. But qualitatively, at least, it gets the problem across. Sought for its own sake, greater stability and predictability of interest rates can come at the cost of less stability in demand and inflation (i.e. the central bank’s ultimate objectives). Chart 6.
Similarly, Bank Rate may be increased more rapidly than anticipated if economic developments raise the outlook for inflation significantly.” Later on, in the summer of 2015, we described guidance about future interest rates, more succinctly, as “an expectation, not a promise”. The time inconsistency of optimal policy: why “low-for-long” guidance may not be as powerful as simple models predict So why, in view of the power of the policy apparent in Chart 4, hasn’t this committed form of guidance been used more often? In their 2015 paper, Del Negro and co-authors claimed that, while it had helped ease monetary conditions, the Fed’s post-crisis guidance had had significantly less impact on demand and inflation than predicted by theory. Their explanation was that, in the real world, demand is less sensitive to forward interest rates than the theory presumes. That’s probably true. Certainly the very simplest models, in which a drop in forward rates five years ahead (say) does almost as much to stimulate spending as a same-sized cut in the current rate, surely exaggerate the impact. But there may also be a more fundamental problem with the policy. It’s intrinsically “time inconsistent” (to use the technical term). From today’s perspective, in the face of a risk of deflation, it would be better if you could persuade people that you will keep policy loose for an extended period, even in the event that inflation rises above target.