Living Up to Expectations: Central Bank Credibility, 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 have imperfect credibility. Exploiting unique survey-based measures of expected inflation, output growth and interest rates, we estimate a small-scale New Keynesian model for the United States and other G7 countries plus Spain allowing for deviations from full information rational expectations. In our model, the key parameter that aggregates heterogeneous expectations captures the central bank's credibility and affects the overall effectiveness of forward guidance. We find that the central banks of the U.S., the U.K., Germany and other major advanced economies have similar levels of credibility (albeit far from full credibility); however, Japan's central bank credibility is much lower. For each country, our measure of credibility has declined over time, making forward guidance less effective. In a counterfactual analysis, we document that inflation would have been significantly higher, and the zero lower bound on short-term interest rates much less of an issue, in the wake of the Global Financial Crisis had the public perceived central bank forward guidance statements to be perfectly credible. Moreover, inflation would have declined more, and somewhat faster, with perfect credibility in the wake of the inflation surge post-COVID-19.

Keywords: forward guidance; central bank credibility; heterogeneous expectations (search for similar items in EconPapers)
JEL-codes: D84 E30 E52 E58 E60 P52 (search for similar items in EconPapers)
Pages: 53
Date: 2023-09-29
New Economics Papers: this item is included in nep-ban, nep-cba, nep-dge, nep-mac and nep-mon
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Related works:
Working Paper: Living Up to Expectations: Central Bank Credibility, the Effectiveness of Forward Guidance, and Inflation Dynamics Post-Global Financial Crisis (2023)
Working Paper: Living Up to Expectations: Central Bank Credibility, the Effectiveness of Forward Guidance, and Inflation Dynamics Post-Global Financial Crisis (2023)
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Persistent link: https://EconPapers.repec.org/RePEc:fip:feddgw:97039

DOI: 10.24149/gwp424

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