The Power of Forward Guidance Revisited

In recent years, central banks have increasingly turned to "forward guidance" as a central tool of monetary policy, especially as interest rates around the world have hit the zero lower bound. Standard monetary models imply that far future forward guidance is extremely powerful: promises about far future interest rates have huge effects on current economic outcomes, and these effects grow with the horizon of the forward guidance. We show that the power of forward guidance is highly sensitive to the assumption of complete markets. If agents face uninsurable income risk and borrowing constraints, a precautionary savings effect tempers their responses to far future promises about interest rates. As a consequence, the ability of central banks to combat recessions using small changes in interest rates far in the future, is greatly reduced relative to the complete markets benchmark. We show that the effects of precautionary savings motives can be captured by a simplified version of our model that generates discounting in the representative agent's Euler equation. This discounted Euler equation can be easily included in standard business cycle models.