The effectiveness of central bank forward guidance under inflation and price-level targeting

Central bank forward guidance has emerged as a pertinent tool for monetary policy authorities since the 2007-2009 Great Recession. However, U.S. inflation has continually missed the Federal Reserve’s target of 2% over the period April 2012 to July 2016. In addition, since the recent global financial crisis, price-level targeting has gained attention due to its predictions of above average inflation in response to deflationary episodes. Thus, it is of interest to investigate whether the effects of forward guidance on the economy can be increased if a central bank switches from inflation to price-level targeting.

This paper examines the effectiveness of central bank forward guidance under inflation and price-level targeting monetary policies. Forward guidance shocks are added to a monetary policy rule in a standard New Keynesian model. The central bank is also assumed to target either inflation or the price level.  

The results show that the attenuation of the effects of forward guidance can be solved if a central bank switches from inflation targeting to price-level targeting. Output and inflation respond more favorably to forward guidance with price-level targeting than inflation targeting. Two reasons drive these results: The inherent history dependence feature of a price-level targeting regime predicts periods of above average inflation (and consequently output) after a deflationary episode. The expectations of agents also react more favorably under price-level targeting than inflation targeting. In addition, a monetary policy rule that aggressively reacts to inflation and includes interest rate inertia narrows the performance gap between the two policy regimes. However, forward guidance with price-level targeting is still preferred to forward guidance with inflation targeting after performing multiple robustness checks.