The Effect of Central Bank Credibility on Forward Guidance in an Estimated New Keynesian Model

Document Type

Article

Publication Date

3-2023

Publisher

Cambridge University Press

Source Publication

Macroeconomic Dynamics

Source ISSN

1365-1005

Original Item ID

DOI: 10.1017/S1365100521000511

Abstract

This paper examines the effectiveness of forward guidance shocks in the US. We estimate a New Keynesian model with imperfect central bank credibility and heterogeneous expectations using Bayesian methods and survey data from the Survey of Professional Forecasters (SPF). The results provide important takeaways: (1) The estimated credibility of the Fed’s forward guidance announcements is relatively high, but anticipation effects are attenuated. Accordingly, output and inflation do not respond as favorably as in the fully credible counterfactual. (2) The so-called “forward guidance puzzle” arises partly from the unrealistically large responses of macroeconomic variables to forward guidance under perfect credibility and homogeneous fully informed rational expectations, assumptions which are found to be jointly inconsistent with the observed US data. (3) Imperfect credibility provides a plausible explanation for the empirical evidence of forecasting error predictability based on forecasting disagreement found in the SPF data. Thus, we show that accounting for imperfect credibility and forecasting disagreements is important to understand the formation of expectations and the transmission mechanism of forward guidance.

Comments

Macroeconomic Dynamics, Vol. 27, No. 2 (March 2023): 532-570. DOI.

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