Fed paper models new transmission channels of forward guidance

Allowing for household borrowing amplifies forward guidance effectiveness, researchers find
Federal Reserve

The ability of households to borrow creates three redistribution mechanisms that amplify the effectiveness of forward guidance in spurring economic activity, researchers from the Federal Reserve find.

In a recent paper, Francesco Ferrante and Matthias Paustian examine the transmission mechanisms of forward guidance on household behaviour. In contrast to other comparable studies, however, the authors examine the effects under a model that allows households to borrow and lend.

“Household debt should be taken into account when evaluating the effectiveness of unconventional monetary policy in incomplete markets models,” the authors argue.

They find there are three key transmission channels: a “transfer news” channel; an interest rate exposure channel; and a debt deflation channel.

The first channel represents a transfer of wealth from saver to borrowers, they say. This is particularly strong for unconstrained borrowers who are likely to become constrained in the future, they find.

As inflation rises following the policy announcement, the interest rate exposure channel lowers the path of the real rate, they add. This increases the wealth of borrowers who have a higher marginal propensity to consume.

The debt deflation channel works as a second redistribution of wealth, they find. If debt is nominal, the forward guidance would create debt deflation, which would generate a wealth transfer towards a “high marginal propensity to consume borrowing-constrained agents”, further increasing economic activity and inflation.

“These channels amplify each other in a liquidity trap, and can make forward guidance more powerful,” they say.

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