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

67 Pages Posted: 14 Jul 2021 Last revised: 11 Jan 2022

See all articles by Stephen J. Cole

Stephen J. Cole

affiliation not provided to SSRN

Enrique Martínez-García

Federal Reserve Bank of Dallas - Research Department

Multiple version iconThere are 3 versions of this paper

Date Written: December, 2019

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.

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

Suggested Citation

Cole, Stephen J. and Martinez-Garcia, Enrique, The Effect of Central Bank Credibility on Forward Guidance in an Estimated New Keynesian Model (December, 2019). Available at SSRN: https://ssrn.com/abstract=3885388 or http://dx.doi.org/10.24149/gwp375r2

Stephen J. Cole (Contact Author)

affiliation not provided to SSRN

No Address Available

Enrique Martinez-Garcia

Federal Reserve Bank of Dallas - Research Department ( email )

2200 North Pearl Street
PO Box 655906
Dallas, TX 75265-5906
United States
214-922-5262 (Phone)

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