Chapter 3. Managing Expectations

Tobias Adrian, Douglas Laxton, and Maurice Obstfeld
Published Date:
April 2018
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Rania Al-Mashat Kevin Clinton Douglas Laxton and Hou Wang

For not only do expectations about policy matter, but, at least under current conditions, very little else matters. —M. Woodford (2005)

The essence of useful monetary policy is effectively managing expectations. This applies both to the policy objectives and to the policy instruments.

The primary, long-term objective of monetary policy is to achieve a sustained environment of low inflation (see, for example, Summers 1991). There is no useful long-term trade-off between inflation and the level of output or employment. Technology, demographics, legal and regulatory structures, education, natural resources, government taxes and spending, national savings and investment, and other nonmonetary factors determine the latter variables.

Bad monetary policy—resulting in unstable or high inflation or deflation—could get in the way of good performance in the real sector. But if the price level is predictable, as it would be in a sustained environment of low inflation, monetary policy does not have a first-order effect on the long-term level of output. The important practical choice for the long-term objective for monetary policy is therefore—explicitly or implicitly—the numerical target for the long-term rate of inflation. For those central banks with a mandate to pursue price stability, this may be rephrased to say that the main practical choice is the definition of price stability as the long-term measured rate of price increase. No practical difference need exist between an explicit inflation target and an explicit price stability objective. Regimes that have an explicit objective, however, differ substantively in their transparency and accountability from those that do not—and they differ in their credibility and effectiveness.

Policy Instruments

To achieve the single policy objective of a sustained environment of low inflation requires at least one policy instrument. The main monetary policy instrument over the short or medium term is usually the key short-term interest rate controlled by the central bank. Modern theoretical models and topical discussions of policy actions focus almost exclusively on this instrument, except under unusual circumstances (which are discussed later in this book). The exchange rate gets a lot of attention too, but deliberate manipulation of the exchange rate, independent of the interest rate, is feasible only over brief periods in a world of high capital mobility. In a small or mid-size economy, the world interest rate and a risk premium set the domestic interest rate via capital mobility. In the long term, the central bank controls neither the interest rate nor the exchange rate.

Through what instrument then does the central bank control the long-term inflation rate? The answer is expectations, and expectations alone. One objective, low inflation, matches one instrument, the management of expectations.

The inflation equation in a conventional macroeconomic model, an expectations-augmented Phillips curve, illustrates the point. It writes current inflation as a function of expected inflation and the output gap. In the long-term equilibrium, actual inflation is equal to expected inflation, and the output gap is zero. The solid red lines in Figure 3.1 illustrate this, using the unemployment rate to represent the output gap: the long-term equilibrium has inflation at the target rate πT and unemployment at the long-term equilibrium rate UE.

Figure 3.1.Phillips Curve Adjustment to Inflation-Reduction Target: Perfect versus Imperfect Policy Credibility

Source: Authors’ construction.

Eventually, the expected rate of inflation prevails, with the Phillips curve vertical at the equilibrium rate of unemployment. From this viewpoint, the main job of monetary policy is to ensure that expectations hold firm at the target rate—in other words, that people have confidence that inflation will continue into the indefinite future at the officially announced rate.

But suppose that at the introduction of a target, inflation has varied around a higher rate, and that expectations have gelled at this rate, π0. To get from there to the new equilibrium at the target rate will in general involve a cost in terms of above-equilibrium unemployment. For example, with the initial Phillips curve, consistent with long-term expected inflation at π0, the central bank may tighten to get immediately to the announced target, πT. The short-term Phillips curve indicates that this implies raising unemployment to U1. Holding inflation at the target rate for long enough will ensure that eventually expectations fall into line. The Phillips curve shifts down, and resettles at the long-term equilibrium, with the unemployment gap back to zero, as indicated by the black arrows. Depending on how the publics expectations adjust, this process may involve a prolonged unemployment gap. However, in a hypothetical case where the central banks announcements have perfect credibility, expectations will go immediately to the target rate, at no unemployment cost, as per the red arrow. During the adjustment to a new inflation target the unemployment cost is lower the more rapidly public expectations adapt to the target, underscoring their key role in transition states.

In addition, the effectiveness of the policy transmission mechanism depends on well-managed expectations. Figure 3.2 illustrates the importance of this point.

Figure 3.2.Phillips Curve: Stable versus Variable Unemployment Rate

Source: Authors’ construction.

As before, the long-term equilibrium is at the target rate of inflation πT and equilibrium unemployment rate UE. However, shocks are always hitting the economy, such that monetary policy cannot hold inflation on target all the time, but only on average. In the figure, half the time inflation is at π1, with unemployment U1; and half the time at π2, U2. On average inflation is on target. But the average unemployment rate is above the deterministic equilibrium rate because of the nonlinearity of the standard Phillips curve: the average UA lies on the chord between the two short-term equilibrium points on the curve.1 More generally, the wider the cyclical fluctuations in the economy, the greater the deadweight loss of output over time. It follows that the more effective monetary policy is as a countercyclical tool, the lower this cost. And in turn, the effectiveness of the policy instrument for this purpose again depends on managing expectations.

If monetary policy interest rate actions are to influence output, it is essential that changes in the policy rate, a very short-term money market rate itself of little relevance to most economic activity, cause changes in the same direction in the longer-term rates at which households and firms borrow and lend. This implies that current changes in the policy rate must, if they are to influence macroeconomic variables at all, affect expectations of the future path of the policy rate.

Thus, managing expectations is crucial in both the long term and the short term. But how best to do this? In the real world, official announcements alone do not work: policymakers earn (or lose) credibility by acting predictably over time to produce results consistent with their declared objectives (or not).

Transparency: Published Interest Rate Forecasts

Full transparency is the simplest way for the central bank to reinforce confidence in the long-term inflation target and to encourage movements in longer-term interest rates. The argument has long been accepted in regard to the objective: inflation-targeting central banks have always insisted that they will achieve their long-term targets and have used all the communications tools at their disposal to convince the public to expect long-term inflation at the target rate, including from the outset a published forecast path on which a medium-term target is also achieved.

In addition, over the short to medium term, publication of the central bank’s own forecast path for the endogenous policy rate, along with other main variables in its macroeconomic forecast, strengthens the policy transmission mechanism. A few central banks have already adopted this approach, including the Reserve Bank of New Zealand and the Czech National Bank. Despite a worry that the public might interpret publication of an interest rate forecast as some kind of commitment on the policy rate, financial markets have readily understood that the rate forecast is subject to change, conditional on unpredictable economic developments.2 The management of expectations through full disclosure of the forecast interest rate path is called conventional forward guidance, to distinguish it from the ad hoc forward guidance that the Federal Reserve and many other central banks have used since the global financial crisis.

Since it typically takes several years for the effects of policy interest actions to be realized, in the forecast a variety of future paths will be consistent with achieving the official inflation target, some more quickly than others. The path chosen by policymakers would reflect their preferences regarding the short-term trade-off between inflation and output. For example, in response to a supply shock, a higher weight on output stability would imply smoother adjustments of the interest rate in response to a given deviation from the inflation target, and a slower return to the target. At any decision point, policymakers must therefore have in mind a time profile for the future policy rate—a conditional path, to be sure, which will change as new data arrive.

Publication of this path would help move expected short-term rates, and hence the whole term structure of interest rates, in support of the transmission mechanism. In terms of objectives, the payoff from this reinforcement of policy effectiveness would be a reduced cost of eliminating deviations of actual inflation from the long-term target rate, or equivalently, an improved short-term output-inflation trade-off (Blanchard and Galí 2007; Laxton and N’Diaye 2002). A connected, but somewhat distinct, argument in favor of publishing the forecast interest rate path is that the information further improves the accountability of the central bank.

Exit Policy

If monetary policy leaves expectations of inflation free to wander, the economy can become trapped in a bad quasi-equilibrium—either very high and unstable inflation or very low inflation (at the worst, deflation)—from which conventional monetary policies offer at best a very costly exit or at worst no exit at all. It is a quasi-equilibrium in that it would not be restored following a lucky shock that put the economy onto a preferred path. These situations call for a coordinated attack using all the main instruments of policy—fiscal, structural, and monetary.3 But a transparent, assertive stance from the central bank can make a big difference. The essence, for better or for worse, is managing expectations—as illustrated in Box 3.1.

One dark corner, which quite a few central banks confront when they first adopt an inflation-targeting regime, is an inflationary environment where people have become accustomed to rapidly rising prices over many years. They have no reason to trust promises from the central bank to disinflate the economy. A tightened monetary stance may result in a steep drop in output, with little to show in the way of lower inflation for years. Unless policymakers have unusually long horizons, the visible output and employment costs of disinflation would exceed the distant perceived benefits. The public would understand the policymakers’ dilemma. As a result, a time-consistent inflationary equilibrium persists, which policymakers have no apparent incentive to change and which people expect to continue. This may be like the situation before India introduced inflation targeting. At the outset of the new regime, the Reserve Bank of India had to change skeptical perceptions about its willingness, or ability, to reduce inflation to the official target range and keep it there.

The dark corner on the other side of the room—a deflation trap—is even more difficult to escape. In the worst-case scenario, conventional monetary policy becomes completely ineffective. The central bank would cut the nominal policy rate to or near zero (the effective lower bound), attempting to stimulate activity and stabilize prices. But with negative and declining inflation the real interest rate (nominal rate minus expected inflation) may be substantially positive and rising. The economy sinks into a hole. Symptoms of this kind have been evident in Japan since 1990. And for some years after the global financial crisis other advanced economies, notably the euro area, experienced a mild but still chronic version of the syndrome—with low inflation, rather than deflation, and a persistent negative output gap.

For almost 10 years, major central banks have maintained policy interest rates at historically low levels, sometimes below zero. With rates slightly above the effective lower bound, policymakers have had little room for further cuts. To provide further monetary stimulus, central banks have used forward guidance for the policy interest rate and quantitative easing through large-scale asset purchases. The intent has been to reduce longer-term rates by a provisional commitment to keep the policy rate low for an extended period or by reducing the term premium in bond yields. Both forward guidance and quantitative easing mainly influence bond rates and primarily through expectations—they strengthen prospects that future short-term rates will remain at the floor for a long period.

To judge from the extremely low levels to which yields fell after these policy actions, forward guidance and quantitative easing did in fact provide monetary policy with additional instruments to reduce borrowing costs. Moreover, positive macroeconomic outcomes—increased output and a decline in unemployment—suggest that these less conventional measures had some effect. In the case of the United States, the Federal Reserve’s actions along these lines contributed to the steady recovery after 2009. The problem in most economies was that the stimulus to output was not strong enough.

Under inflation-forecast targeting, forward guidance can be considered an ongoing process in which the central bank provides a continuous flow of information on its current policy actions and on its view of what medium-term actions may be appropriate. During a period in which the effective lower bound is indeed binding and where the main danger is deflation the central bank would publish a forecast with an endogenous interest rate near the floor for long enough to get inflation back on track. To the extent that the forecast affects market expectations, it will move medium- and long-term rates down, in line with the objective of shifting the economy away from the low-inflation trap.

Publication of the forecast is thus an instrument that helps policy achieve its objectives, in effect like the Fed’s forward guidance.4 However, the strategy of the most transparent inflation-forecast-targeting central banks emerges from a framework that applies always, not just during a dark corner. The principle that underlies the effectiveness of forward guidance applies more generally: if the markets understand where monetary policy is heading, they are likely to move interest rates in a direction that supports policy. It follows that releasing that path would be the single most obvious way of clarifying for the public the policy implications of the economic outlook. Moreover, the ongoing nature of the commitment under inflation-forecast targeting provides assurance that the response to shocks in the future will be just as vigorous, since the central bank communicates to the public not just a conditional path for the future policy rate, but also a rationale for it, and a sense of how this expected path might change when unexpected developments arise. This underlines the conditionality of the current central bank forecast at the same time that it is strengthening confidence in the long-term outlook.

Box 3.1.Policy Expectations May Absorb or Amplify Shocks

Figure 3.1.1 illustrates a contractionary shock. In response, in normal times, the central bank would cut the policy rate. The effect on the economy depends on how people interpret this action.

Figure 3.1.1.Expectations as Absorbers or Amplifiers Follow a Contractionary Shock

Source: Authors’ construction.

Note: QE = quantitative easing.

Credibility results in shock absorption. If the rate hike is perceived as the assertive response of a credible central bank, inflation expectations for the longer term remain stable, and the policy action lowers the real interest rate.

In addition, uncovered interest parity implies a depreciation in the real exchange rate:

Notation: r, real interest rate; z, real exchange rate (up means a depreciation); rf, foreign real interest rate; µ, country risk premium.

A similar argument applies to asset prices, which would also rise. The easier monetary conditions, and the induced wealth effect, stimulate demand, and narrow—eventually eliminating—the negative output gap. Inflation returns without unusual delay to the long-term target rate.

Lack of credibility, however, can lead to shock amplification.

In the unusual time of a low-inflation trap, with the interest rate at the effective lower bound, the risk of a worse outcome is greater. With falling expectations of inflation, or rising expectations of deflation, the real interest rate would increase, the real exchange rate would appreciate, and asset prices would fall:

This is the classic deflation trap. An assertive reflationary policy stance is then required. Since the nominal interest rate can go no lower, the central bank must persuade people not only that the nominal interest rate will remain at the floor for an extended period and that the rate of inflation will rise over the medium term (possibly above the long-term target), but also that the rate of inflation will eventually return to target. Clearly, everything depends on the ability of the monetary policymakers to manage the expectations of the public.

Evidence on Managing Expectations Under Inflation Targeting

Given the susceptibility of an economy to many kinds of disturbances, the inflation rate is bound to vary from year to year, and it will sometimes deviate substantially from the objective of the central bank, regardless of the policy regime or the skill of the policymakers. Targeting errors need not, however, undermine the credibility of monetary policy. The foundation for the credibility is not so much precision in achieving an announced objective—although that would surely help—but instead the expectation that monetary policy will systematically respond to any deviations in such a way that the long-term objective will be achieved. The evidence in the following subsections suggests that a well-designed and well-executed inflation-targeting regime instills such confidence. It also suggests that in the early, credibility-building phase any failure to follow through on the commitment to a policy response consistent with the inflation target can cause confusion and destabilize expectations—with a costly macroeconomic impact.

United Kingdom 1997

This episode provided an early indication of the power of a credible inflation targeting announcement (Escolano and others 2000). Before 1997 the United Kingdom had a peculiar inflation-targeting arrangement: the Chancellor of the Exchequer (finance minister), not the Bank of England, set the policy interest rate. In May 1997, a reform transferred this responsibility to the Monetary Policy Committee of the central bank. The reform also provided for increased transparency and accountability. It required publication of minutes of the monthly Monetary Policy Committee meeting. The target shifted, from a 1–4 percent range, to the midpoint of that range, 2.5 percent. And if inflation diverges over a year from the target, the governor now must write an open letter to the Chancellor explaining why and outlining what the Monetary Policy Committee will do to rectify the deviation. In brief, the reform set up an orthodox inflation-targeting policy framework, with instrument independence for the central bank.

The inflation premium on long-term bond yields declined. Ten-year inflation expectations, as gauged by the difference in yields between nominal and indexed bonds, dropped from more than 4 percent to 2.5 percent (the target rate)—and they stabilized around that rate (Figure 3.3). The announcement of the reform provided a large boost to confidence in monetary policy, eliminating the credibility gap evident in bond yields, even before the regime had demonstrated it would deliver on its commitments.

Figure 3.3.Inflation Expectations 10 Years ahead in the United Kingdom, 1995–99


Emerging Market Economies

During the great moderation period before 2008, inflation performance across advanced economies was uniformly good, with no large difference between inflation targeters and others. The differences among emerging market economies, however, were substantial. Batini, Kuttner, and Laxton (2005) find that within this group inflation targeting was associated with lower inflation, lower inflation expectations, and lower inflation volatility compared with countries that did not adopt inflation targeting. Inflation targeting did not appear to hurt output, or other dimensions of economic performance—for example, the volatility of interest rates, exchange rates, and international reserves.

Israel 2001–07

In late 2001, responding to weakness in output after the collapse of the bubble and a steep rise in unemployment, the Bank of Israel cut the policy rate 200 basis points (Argov and others 2007). The new sheqel depreciated. Headline inflation rose to 7 percent by July 2002, much more than the 3 percent top of the target band (Figure 3.4). In response, the Bank of Israel raised the policy rate by 450 basis points in three steps and then held it at around 9 percent until mid-2003, even though the economy was still in recession.

Figure 3.4.Israel: Interest Rates, Inflation, and Exchange Rates, 2001–04


Sources: Argov and others 2007; Bank of Israel; Central Bureau of Statistics; and IMF staff estimates.

Note: NIS = new sheqel.

Inflation dropped below zero in the second half of 2003 and the first half of 2004, yet inflation expectations were consistently above the 1–3 percent band. The real policy rate—the nominal rate less expected inflation one year ahead—rose to 6 percent during the second half of 2002 and remained around there through mid-2003, when the economy was still struggling to recover from recession. The abrupt changes in the policy rate in response to changes in current economic conditions at that time destabilized inflation expectations and economic activity.

These events contrasted with the more forward-looking approach to inflation targeting that the Bank of Israel later adopted. In 2006, headline inflation overshot the upper band (Figure 3.5). Much of this was due to one-time pass-through effects of exchange rate depreciation and a steep increase in oil prices. But some monetary policy response was required because spare capacity in the economy was limited. The central bank interest rate increase was measured, yet it did succeed in stabilizing inflation expectations.

Figure 3.5.Israel: Interest Rates, Inflation, and Exchange Rates, 2005–07


Sources: Argov and others 2007; Bank of Israel; Central Bureau of Statistics; and IMF staff estimates.

Note: NIS = new sheqel.

These episodes illustrate that credibility is put at risk when the actual policy appears to be at odds with the announced objective. More positively, they also show that external shocks do not undermine credibility as long as the central bank’s reaction is consistent with the objective.

A Multicountry Sample 2015–17

Each dot in the scatter diagram in Figure 3.6 relates the Consensus forecast of inflation three years ahead (vertical axis) to a given year’s inflation rate (horizontal axis). Inflation is measured as the deviation from the official target. The data shown are from the 12 Consensus long-term forecasts conducted during 2015–17.

Figure 3.6.Deviation of Consensus Headline Inflation Forecasts from Target

(Percentage point)

Source: Consensus Economics 2015–17.

Notes: Inflation-forecast-targeting (IFT) economies are indicated by green diamonds and include Canada, the Czech Republic, New Zealand, Sweden, and the United States. Euro area economies are indicated by blue squares. Japan is indicated by red dots.

The diamonds for most inflation-forecast-targeting countries are grouped close to the horizontal axis. This implies that inflation expectations in these countries have been close to the inflation target, regardless of the current rate of inflation. Most other inflation-forecast-targeting countries are in the upper-left quadrant: that is, although their current inflation has been below target, forecasters expect future inflation to be above target. For stabilizing the economy, this is a good outcome, especially with the policy rate near zero, as the expected inflation overshoot reduces real interest rates and therefore stimulates output and pushes inflation back toward target.

The scatter of points for those countries not following inflation-forecast targeting all fall in the lower-left quadrant. That is, inflation has been below target, and forecasters expect this to continue: expectations have drifted with the current rate of inflation. This is a terrible outcome because the below-target expectations raise real interest rates and compound the low-inflation problem. These data therefore provide strong evidence that expectations have been better anchored in economies where monetary policy follows inflation-forecast-targeting principles.

Risk Avoidance

Preventing a bad quasi-equilibrium is much better than having to find an effective cure. Therefore, the most appropriate policy response is one that is increasingly strong and increasingly risk-avoiding as an economy approaches a bad monetary equilibrium. Conventional rules that suggest a measured, linear response are no longer a useful characterization of policy under these circumstances.5 A reaction function based on a quadratic loss function better captures an appropriate risk-avoidance strategy. The loss function implies an increasing response at the margin as negative deviations from the target grow and as economic slack increases. Model simulations show that, in response to a negative shock at the effective lower bound, with inflation already below target, and with a negative output gap, the optimal strategy holds the policy rate at the lower bound for a lengthy period (examples are provided in Chapter 9 for Canada and Chapter 10 for the Czech Republic). Publishing this outlook in a central bank forecast would lower expectations for interest rates over the medium term and reduce the exchange value for the currency. This would boost demand and inflation—indeed, inflation may temporarily overshoot the target in the medium term. Under these circumstances, the overshoot would be welcome. It helps to offset the negative influence of the starting point on long-term inflation expectations, reinforcing the nominal anchor. At the same time, with the nominal policy rate stuck at the floor, the increased medium-term inflation lowers real interest rates, reinforcing the transmission of the policy action.

This highlights a practical advantage of the systematic approach to policy formulation and communication under a transparent inflation-forecast-targeting regime: the central bank does not have to announce the time horizon of the guidance nor list the data-dependent threshold conditions that would switch it off. These thresholds, particularly relating to the unemployment rate, have in practice proved unreliable. For example, the Fed has had to change its forward guidance policy several times in these respects since 2008. This gave the impression of improvisation, rather than a predictable policy.6 The difficulty would be magnified if, as discussed above, the central bank deliberately plans a temporary overshoot of the long-term inflation target in an assertive anti-deflation strategy. If this outcome were realized without full publication of the central bank forecast, people might think the switch was left on too long and question the central bank’s commitment to inflation control.


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Debelle and Laxton (1997) make this point, distinguishing the natural rate of unemployment from the rate consistent with non-accelerating inflation.


Freedman and Laxton (2009) discuss this issue in more depth.


Gaspar and others (2016) present the argument in the context of below-target inflation, and wide output gaps, in some large advanced economies.


Bernanke (2013) provides an authoritative description of the evolution of forward guidance at the Fed.


This includes the Taylor rule, which posits that the nominal interest rate should respond to divergences of actual inflation rates from target inflation rates in the short term.


For a discussion of the US experience, see Alichi and others (2015).

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