Should Central Banks Communicate Uncertainty in Their Projections?
46 Pages Posted: 2 Mar 2020 Last revised: 23 Nov 2020
Date Written: November 1, 2020
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: Suggested Citation