Quantitative forward guidance through interest rate projections

Summary

Focus

Forward guidance on the future path of policy rates has become a key element of central banks' monetary policy toolbox over the past decade. This paper analyses quantitative forward guidance through the publication of interest rate projections, a practice pursued by some inflation targeting central banks.

Contribution

Based on the experiences of the Reserve Bank of New Zealand, the Norges Bank, Sveriges Riksbank and the Federal Reserve, this paper looks at the effectiveness of quantitative forward guidance in terms of their (i) predictability, the extent to which markets are able to anticipate the central bank path; (ii) credibility, the ability of central banks to steer market interest rates through the quantitative guidance provided; (iii) redundancy, whether the central bank interest rate projections provide information beyond that provided through projections of key target variables (eg inflation or the output gap); and (iv) consistency, whether central bank interest rate projections are consistent with the published projections of policy target variables.

Findings

We find that the interest rate projections released by these four central banks are predictable and credible but only in a limited way. Market expectations of the future path of short-term interest rates do anticipate changes in the central bank projection path to a significant degree, yet far from completely. At the same time, market interest rates adjust to path surprises. The adjustment is, however, far from one to one, and weakens as the projection horizon lengthens. We further find that interest rate projections are not redundant in terms of information content. Their impact on market expectations remains significant also when controlling for the effects of central bank macroeconomic projections. Finally, central bank interest rate projections are consistent with central bank macroeconomic projections. The projections are consistent with a widely used rule linking interest rates to inflation and the output gap.

Abstract

We assess quantitative forward guidance through interest rate projections along four key dimensions: (i) predictability, (ii) credibility, (iii) redundancy and (iv) consistency. Based on data for the Reserve Bank of New Zealand, the Norges Bank, the Sveriges Riksbank and the Federal Reserve, we find that the interest rate projections released by these four central banks are predictable and credible, but in limited ways. Market expectations of the future path of interest rates predict changes in the central bank projection path, but far from fully. Central bank paths' credibility is limited as markets adjust to path surprises, but far from a one-to-one basis. Both predictability and credibility decrease with the projection horizon. We further find that central bank interest rate projections are not redundant as they impact market expectations also when controlling for the effects of central bank macro projections that are released in parallel. Finally, the interest rate projections are consistent with the macro projections as they are empirically linked by a stabilising Taylor rule.       

JEL classification: E52, E58.

Keywords: forward guidance; interest rate projections; central bank communication.