Evaluating Quantitative Easing: The Importance of Accounting for Forward Guidance

Abstract

Brent Bundick is a senior research and policy advisor and A. Lee Smith is a vice president and economist at the Federal Reserve Bank of Kansas City. Logan Hotz, a research associate at the bank, helped prepare the article. This article is on the bank’s website at www.KansasCityFed.org On March 15, 2020, the Federal Open Market Committee (FOMC) lowered the federal funds rate—its primary policy tool—to its effective lower bound in response to the pandemic-induced contraction in economic activity. At the same time, the FOMC began engaging in large-scale asset purchases (LSAPs) and provided forward guidance about the future path of the funds rate. Both LSAPs and forward guidance are less conventional tools that the FOMC also deployed to combat the Great Recession of 2007–09. Although the Great Recession and pandemic crisis were driven by very different factors, policymakers in both periods looked to LSAPs and forward guidance to help stabilize financial markets and promote maximum employment and price stability. In theory, LSAPs support the economy by putting downward pressure on longer-term interest rates and improving the flow of credit to households and firms. However, policymakers and economists have yet to reach a consensus on how effective LSAPs are in providing accommodation and improving macroeconomic outcomes. One common approach to measuring the effectiveness of these tools is to study how financial markets respond to announced changes in LSAPs and forward guidance. But the market responses to these tools can be difficult to disentangle because announced changes in LSAPs often coincide with