Forward guidance reassessed: Stabilizability under endogenous policy rules

It is well known that, in a world of rational expectations, time inconsistency is at the heart of policy failures. Strategic policy announcements in the form of forward guidance have assumed a more important role particularly when expansionary monetary policy is blocked by the zero lower bound (ZLB). This paper deals with the possibility that policy announcements avoid time inconsistency. This makes monetary policy more credible. Nevertheless, the non-credibility of an announcement of future policy can derive from a number of obstacles, including the possibility that the economy is hit by some kinds of shocks, particularly large-sized shocks. We show that shocks of any size can always be controlled by suitable policy rules if their design includes forward guidance and state contingent policy rules, as well as an appropriate but not restrictive choice of the policy parameters. This provides enhanced controllability and stabilize-ability – in particular in those cases where those properties had not been available before. To illustrate, we provide examples based on a dynamic representation of a reduced form DSGE model derived from the New Keynesian (NK) approach to modeling the economy. It turns out that there are some differences between the bounds on the permitted policy parameters which depend on whether we are tied to the ZLB or not. But stabilizing policy rules under forward guidance are always feasible and always available.