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

RePEc Short ID: pma614
ORCID iD: 0000-0001-5736-361X

Cole, Stephen J.; Martínez García, Enrique

doi:10.24149/gwp375r1

Working Paper Revision

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

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 a degree of forward guidance effectiveness, but still one that is below the fully credible case. Hence, anticipation effects are attenuated and, accordingly, output and inflation do not respond as favorably to forward guidance announcements. (2) Imperfect central bank credibility is an important feature to resolve the so-called “forward guidance puzzle,” which the literature shows arises from the unrealistically large responses of macroeconomic variables to forward guidance statements in structural models with perfect credibility. (3) Imperfect monetary authority credibility can also explain 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; Expectations; Monetary Policy; Central Bank Credibility;

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

https://doi.org/10.24149/gwp375r1