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

Stephen Cole () and Enrique Martinez-Garcia
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Enrique Martinez-Garcia:

Authors registered in the RePEc Author Service: Enrique Martínez García ()

No 375, Globalization Institute Working Papers from Federal Reserve Bank of Dallas

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 (search for similar items in EconPapers)
JEL-codes: D84 E30 E50 E52 E58 E60 (search for similar items in EconPapers)
Pages: 68
Date: 2019-12-16, Revised 2021-03-20
New Economics Papers: this item is included in nep-cba, nep-mac, nep-mon and nep-ore
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DOI: 10.24149/gwp375r2

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