The Power of Open-Mouth Policies

When a central bank announces a policy it will not implement for some time, households and firms respond straight away. This paper measures how much of a policy’s effect arrives in that anticipation window. The obstacle is technical: an announced, dated, one-off policy change is not a recurrent draw from a stationary process, so it produces a nonstationary solution — a different decision rule in every period — that conventional methods, which construct a single time-invariant decision rule, cannot represent. The authors develop a perturbation-based extended function path (EFP) method to build that sequence of time-dependent decision rules, and apply it to a scaled-down replica of the Bank of Canada’s ToTEM projection model. Across five experiments they find the anticipation effects are large for two of them and modest for the other three: a gradual rise in the inflation target from 2% to 3% raises output by about 0.2% at its peak when implemented immediately and by about 0.3% when announced a year ahead, and forward guidance about lifting off from the effective lower bound raises the peak output response by about 70% when the return to the Taylor rule is postponed from four quarters to eight — while switching to a more aggressive Taylor rule, to price-level targeting or to average inflation targeting produces only minor anticipatory effects in an economy not otherwise hit by shocks. Comparing their solution with a Markov news-shock treatment of the same experiment, they find the Markov version “significantly overstates the importance of a given anticipated event”, with peak anticipation effects in investment five times larger, because a unit-root news process implies the effects persist forever. (The full text read for this summary is the authors’ manuscript of November 16, 2024, which carries the same abstract, model and five experiments as the published article; magnitudes may have moved in revision.)

Serguei Maliar | Macro Paper Warehouse

The Power of Open-Mouth Policies