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

Cole, Stephen J.; Martínez García, Enrique

doi:10.24149/gwp375r2

Working Paper Revision

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

Abstract: This paper examines the effectiveness of forward guidance in an estimated New Keynesian model with imperfect central bank credibility. We estimate credibility for the U.S. Federal Reserve with Bayesian methods exploiting survey data on interest rate expectations from the Survey of Professional Forecasters (SPF). The results provide important takeaways: (1) The estimate of Federal Reserve credibility in terms of forward guidance announcements is relatively high, which indicates muted forward guidance effectiveness relative to the fully credible case. Hence, anticipation effects are attenuated and, accordingly, output and inflation do not respond as favorably to forward guidance announcements. (2) The so-called “forward guidance puzzle” is shown to arise, at least in part, from the unrealistically large responses of macroeconomic variables to forward guidance statements in structural models that do not incorporate imperfect credibility and heterogeneous expectations. (3) Imperfect monetary authority credibility provides a plausible explanation to the evidence of forecasting error predictability based on forecasting disagreement found in the SPF data. Thus, accounting for imperfect credibility is important to model the formation of expectations in the economy and to understand the transmission mechanism of forward guidance announcements.

Keywords: Forward Guidance; Monetary Policy; Expectations; Central Bank Credibility;

JEL Classification: D84; E30; E50; E52; E58; E60;

https://doi.org/10.24149/gwp375r2