Living Up to Expectations: The Effectiveness of Forward Guidance and Inflation Dynamics Post-Global Financial Crisis

Stephen Cole, Enrique Martínez García () and Eric Sims ()

No 424, Globalization Institute Working Papers from Federal Reserve Bank of Dallas

Abstract: This paper studies the effectiveness of forward guidance when central banks face private agents with heterogeneous expectations allowing for a degree of bounded rationality. Exploiting unique survey-based measures of expected inflation, output growth and interest rates, we estimate a small-scale New Keynesian model with forward guidance shocks for the United States and the other G7 countries plus Spain. We find that the share of fully-informed rational expectations (FIRE) agents in aggregate expectations is similar for the U.S., the U.K., Germany and other major advanced economies (albeit far from one); however, Japan’s share is much lower. For each country, the estimate of the share of FIRE agents has declined over time as VAR-based expectations—the heuristic approach assumed under bounded rationality—became more prominent in explaining the more recent data. Forward guidance has correspondingly grown less effective. In a counterfactual analysis, we document that, in the wake of the global financial crisis, inflation would have been significantly higher and the zero lower bound on short-term interest rates much less of a constraint had the public fully incorporated central banks’ forward guidance statements as FIRE agents do. Moreover, inflation would have declined more, and somewhat faster, in the wake of the post-COVID-19 inflation surge as well.

Keywords: forward guidance; monetary policy; heterogeneous expectations; expectations formation; VAR-based forecasting (search for similar items in EconPapers)
JEL-codes: D84 E30 E52 E58 E60 P52 (search for similar items in EconPapers)
Pages: 57
Date: 2023-09-29, Revised 2025-04-03
New Economics Papers: this item is included in nep-ban, nep-cba, nep-dge, nep-mac and nep-mon
Note: Previous version was titled, "Living Up to Expectations: Central Bank Credibility, the Effectiveness of Forward Guidance and Inflation Dynamics Post-Global Financial Crisis."
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Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:fip:feddgw:97039

DOI: 10.24149/gwp424r1

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