Imperfect Credibility and the Zero Lower Bound on the Nominal Interest Rate

When the nominal interest rate reaches its zero lower bound, credibility is crucial for conducting forward guidance. We determine optimal policy in a New Keynesian model when the central bank has imperfect credibility and cannot set the nominal interest rate below zero. In our model, an announcement of a low interest rate for an extended period does not necessarily reflect high credibility. Even if the central bank does not face a temptation to act discretionarily in the current period, policy commitments should not be postponed. Nevertheless, even banks with low credibility should use forward guidance to the best of their abilities. In reality, central banks are often reluctant to allow a recovery path with output and inflation temporarily above target. From the perspective of our model such a policy reflects a low degree of credibility. We find increased forecast uncertainty in inflation and the output gap at the zero lower bound while interest rate uncertainty is reduced. This change in uncertainty is more pronounced for policymakers with less credibility. Furthermore, misalignments between announced interest rate paths and market expectations are found to be best explained by lack of credibility.