Credible Forward Guidance
How can the central bank credibly implement a “lower-for-longer” strategy? To answer this question, we analyze credible forward guidance policies in a sticky-price model with an effective lower bound (ELB) constraint on nominal interest rates by solving a series of optimal sustainable policy problems indexed by the duration of reputational loss. Lower-for-longer policies – while effective in stimulating the economy at the ELB – are potentially time-inconsistent, as the associated overheating of the economy in the aftermath of a crisis is undesirable ex post. However, if reneging on a lower-for-longer promise leads to a loss of reputation and prevents the central bank from effectively using lower-for-longer policies in future crises, these policies can be time-consistent. We find that, even without an explicit commitment technology, the central bank can still credibly keep the policy rate at the ELB for an extended period – though not as extended under the optimal commitment policy – and meaningfully mitigate the adverse effects of the ELB constraint on economic activity.