Forward guidance supercharges monetary policy transmission

Background and Motivation

As the pioneer of inflation targeting in 1990, New Zealand's monetary policy framework has been a model for central banks globally. In recent years, tools like forward guidance—where a central bank communicates its likely future policy actions—have become essential. However, a critical question remains: does this guidance actually make monetary policy more effective? This study investigates the specific impact of forward guidance on interest rate pass-through—the process by which changes in the central bank's official cash rate are transmitted to the interest rates that commercial banks offer to households and businesses. The motivation is to provide empirical evidence on whether forward guidance strengthens this crucial channel of monetary policy.

Methodology and Scope

This research rigorously analyses the interest rate pass-through within the New Zealand banking system. To provide a comprehensive view, the study separately estimates both the long-term and short-term dynamics of pass-through. The methodology employs:

• Dynamic OLS: Used to estimate the long-term equilibrium relationship between the Official Cash Rate (OCR) and various bank rates, including time-deposit rates and lending rates.
• Error Correction Model: Applied to capture the speed and extent of short-term adjustments towards the long-term equilibrium.

The scope encompasses a range of interest rates, allowing for a detailed comparison of how forward guidance affects different products, from savings accounts to mortgages.

Key Findings and Contributions

• Enhanced Long-Term Pass-Through: The implementation of forward guidance leads to a stronger long-term relationship between the policy rate and bank rates. This effect is particularly pronounced for time-deposit rates and longer-term fixed mortgage rates.
• Improved Short-Term Dynamics: Following the adoption of forward guidance, the markup on various lending rates decreased, and the speed of short-term pass-through increased slightly. This indicates that banks adjust their rates more promptly and fully to policy changes.
• A Novel Contribution: As the first paper to directly examine the impact of forward guidance on interest rate pass-through, it provides a missing piece of the puzzle for why central bank communication is so powerful.

Why It Matters

This research holds profound importance for the global economic community. It moves the discussion on forward guidance from theory to measurable impact. For central banks like the Federal Reserve and the European Central Bank, which have heavily relied on forward guidance, this study offers robust validation of its effectiveness. It confirms that clear communication is not just about managing expectations but actively improves the transmission mechanism of monetary policy, making it a more potent tool for stabilising inflation and supporting the economy.

Practical Applications

• For Central Bankers: The evidence strongly supports the continued and strategic use of forward guidance to ensure that policy decisions are efficiently transmitted to the real economy through the banking sector.
• For Commercial Banks: The research indicates that forward guidance allows banks to anticipate future funding costs more accurately, enabling them to adjust their deposit and loan rates more quickly and strategically in response to the monetary policy outlook.
• For Businesses and Households: Understanding that forward guidance makes bank rates more responsive to central bank actions helps borrowers and savers make more informed long-term

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