policymakers demonstrate

424 Charles Brendon and Giancarlo Corsetti
be made in favour of specific, implementable rules, and this should be a focus
of the literature.
An alternative to state-contingent forward guidance is to promise that nominal
interest rates will remain at a specified level over a specified period of
time – an approach the Federal Reserve experimented with in 2011 and 2012.
Yet as Woodford (2012) has argued, a risk associated with this is that it may
be misinterpreted by market participants as a signal that the central bank is
more pessimistic about the future evolution of the economy than previously
believed. This may in turn induce greater uncertainty about the variables that
matter – output and employment – than in the absence of such ‘guidance’. The
more uncertain is future income, the higher are the marginal benefits from saving,
and the natural rate shock is exacerbated rather than mitigated. 21 Practical
measures for ensuring guidance operates as intended ought to be a focal point
for future research. 22
An issue of specific relevance to the Eurozone is the interaction between
exchange rate policy and the effects of forward guidance. Corsetti et al. (2011)
and Cook and Devereux (2014) have drawn attention to the similarities between
the role played by future rate commitments in the canonical Eggertsson-
Woodford framework, and the impact on future price expectations of membership
of a currency union. Suppose that a small, open economy were to be
affected by a negative natural rate shock, of the sort discussed above. So long as
demand remains suppressed, the likely effect of this shock is to keep domestic
inflation below levels elsewhere. If the country is a member of a currency union,
however, the gradual effect of low current inflation is to raise consumer beliefs
about the rate of price growth that must obtain when normal times return –
and domestic prices return closer to the levels of other countries within the
union. This high expected price growth is precisely what forward guidance in
a closed economy is seeking to engineer. Thus in theory a commitment to be –
andremain–amemberofacurrencyunionshould help in placing a limit on
the deflationary consequences of negative natural rate shocks. Of course, an
obvious question raised by this research is why southern countries in the Eurozone,
in particular Greece, do not appear to have benefitted from this automatic
cushion. A likely possibility is that Greece was widely perceived to have had
an overvalued real exchange rate prior to the crisis, and thus consumer expectations
are far from the point where relatively high inflation is seen as a likely
consequence of continued membership of the currency area – quite the opposite.
We end the discussion of forward guidance on a more cautionary note, which
has been sounded by the recent work of McKay et al. (2015). These authors
emphasize that the overwhelming share of research advocating forward guidance
as a normative option has been conducted in New Keynesian models,
assuming that financial markets are complete and households are perfectly able