Should Central Banks Communicate Uncertainty in Their Projections?

46 Pages Posted: 2 Mar 2020 Last revised: 23 Nov 2020

See all articles by Ryan Rholes

Ryan Rholes

Texas A&M University - Department of Economics

Luba Petersen

Simon Fraser University (SFU) - Department of Economics

Date Written: November 1, 2020

Abstract

This paper provides original empirical evidence on the emerging practice by central banks of communicating uncertainty in their inflation projections. We compare the effects of point and density projections in a learning-to-forecast laboratory experiment where participants' aggregated expectations about one- and two-period-ahead inflation influence macroeconomic dynamics. Precise point projections are more effective at managing inflation expectations. Point projections reduce disagreement and uncertainty while nudging participants to forecast rationally. Supplementing the point projection with a density forecast mutes many of these benefits. Relative to a point projection, density forecasts lead to larger forecast errors, greater uncertainty about own forecasts, and less credibility in the central bank's projections. We also explore expectation formation in individual-choice environments to understand the motives for responding to projections. Credibility in the projections is significantly lower when strategic considerations are absent, suggesting that projections are primarily effective as a coordination device. Overall, our results suggest that communicating uncertainty through density projections reduces the efficacy of inflation point projections.

Keywords: expectations, monetary policy, inflation communication, credibility, laboratory experiment, experimental macroeconomics, uncertainty, strategic, coordination, group versus individual choice

JEL Classification: C9, D84, E52, E58

Suggested Citation

Rholes, Ryan and Petersen, Luba, Should Central Banks Communicate Uncertainty in Their Projections? (November 1, 2020). Available at SSRN: https://ssrn.com/abstract=3529832 or http://dx.doi.org/10.2139/ssrn.3529832

Ryan Rholes

Texas A&M University - Department of Economics

5201 University Blvd.
College Station, TX 77843-4228
United States

Luba Petersen (Contact Author)

Simon Fraser University (SFU) - Department of Economics ( email )

8888 University Drive
Burnaby, British Columbia V5A 1S6
Canada

HOME PAGE: http://www.sfu.ca/~lubap

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