Skip to main content Accessibility help
×
Home
Hostname: page-component-5d6d958fb5-ls6xp Total loading time: 0.46 Render date: 2022-11-28T23:14:45.114Z Has data issue: true Feature Flags: { "shouldUseShareProductTool": true, "shouldUseHypothesis": true, "isUnsiloEnabled": true, "useRatesEcommerce": false, "displayNetworkTab": true, "displayNetworkMapGraph": false, "useSa": true } hasContentIssue true

The effect of central bank credibility on forward guidance in an estimated New Keynesian model

Published online by Cambridge University Press:  15 November 2021

Stephen J. Cole
Affiliation:
Department of Economics, Marquette University, P.O. Box 1881, Milwaukee, WI 53201, USA
Enrique Martínez-García*
Affiliation:
Federal Reserve Bank of Dallas, 2200 N. Pearl Street, Dallas, TX 75201, USA
*
*Corresponding author: Enrique Martínez-García. Email: emg.economics@gmail.com

Abstract

This paper examines the effectiveness of forward guidance shocks in the US. We estimate a New Keynesian model with imperfect central bank credibility and heterogeneous expectations using Bayesian methods and survey data from the Survey of Professional Forecasters (SPF). The results provide important takeaways: (1) The estimated credibility of the Fed’s forward guidance announcements is relatively high, but anticipation effects are attenuated. Accordingly, output and inflation do not respond as favorably as in the fully credible counterfactual. (2) The so-called “forward guidance puzzle” arises partly from the unrealistically large responses of macroeconomic variables to forward guidance under perfect credibility and homogeneous fully informed rational expectations, assumptions which are found to be jointly inconsistent with the observed US data. (3) Imperfect credibility provides a plausible explanation for the empirical evidence of forecasting error predictability based on forecasting disagreement found in the SPF data. Thus, we show that accounting for imperfect credibility and forecasting disagreements is important to understand the formation of expectations and the transmission mechanism of forward guidance.

Type
Articles
Copyright
© The Author(s), 2021. Published by Cambridge University Press

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

Adjemian, S., Bastani, H., Juillard, M., Mihoubi, F., Perendia, G., Ratto, M. and Villemot, S. (2011) Dynare: Reference Manual, Version 4. CEPREMAP. Dynare Working Papers 1. https://bit.ly/2Y3TdsW.Google Scholar
Aguilar, P. and Vázquez, J. (2019) An estimated DSGE model with learning based on term structure information. Macroeconomic Dynamics, First View, 1–31. https://doi.org/10.1017/S1365100519000816 CrossRefGoogle Scholar
Andrade, P., Gaballo, G., Mengus, E. and Mojon, B. (2019) Forward guidance and heterogeneous beliefs. American Economic Journal: Macroeconomics 11(3), 129. https://doi.org/10.1257/mac.20180141.Google Scholar
Andrade, P. and Le Bihan, H. (2013) Inattentive professional forecasters. Journal of Monetary Economics 60(8), 967982. https://doi.org/10.1016/j.jmoneco.2013.08.005.CrossRefGoogle Scholar
Bernanke, B. S., Kiley, M. T. and Roberts, J. M. (2019). Monetary policy strategies for a low-rate environment. American Economic Review Papers and Proceedings 109, 421426. https://doi.org/10.1257/pandp.20191082.CrossRefGoogle Scholar
BIS (2019) Unconventional Monetary Policy Tools: A Cross-Country Analysis. Committee on the Global Financial System (CGFS) Papers No. 63. Report prepared by a Working Group chaired by Simon M. Potter (Federal Reserve Bank of New York) and Frank Smets (European Central Bank). Bank for International Settlements. https://www.bis.org/publ/cgfs63.pdf.Google Scholar
Blinder, A. S. (2018) Through a crystal ball darkly: The future of monetary policy communication. American Economic Review Papers and Proceedings 108, 567571. https://doi.org/10.1257/pandp.20181080.CrossRefGoogle Scholar
Branch, W. A. and McGough, B. (2009) A new Keynesian model with heterogeneous expectations. Journal of Economic Dynamics and Control 33(5), 10361051. https://doi.org/10.1016/j.jedc.2008.11.007.CrossRefGoogle Scholar
Bundick, B. and Smith, A. L. (2020) Should We Be Puzzled by Forward Guidance? Federal Reserve Bank of Kansas City Research Working Papers No. 20-01. https://doi.org/10.18651/rwp2020-01.CrossRefGoogle Scholar
Caldara, D., Gagnon, E., Martínez-García, E., and Neely, C. J. (2020) Monetary Policy and Economic Performance Since the Financial Crisis. Globalization Institute Working Paper 399. https://doi.org/10.24149/gwp399.Google Scholar
Calvo, G. A. (1983) Staggered prices in a utility-maximizing framework. Journal of Monetary Economics 12(3), 383398. https://doi.org/10.1016/0304-3932(83)90060-0.CrossRefGoogle Scholar
Campbell, J. R., Evans, C. L., Fisher, J. D., and Justiniano, A. (2012) Macroeconomic effects of federal reserve forward guidance. Brookings Papers on Economic Activity 2012(1), 180. Project MUSE. https://doi.org/10.1353/eca.2012.0004.CrossRefGoogle Scholar
Campbell, J. R., Ferroni, F., Fisher, J. D. and Melosi, L. (2019) The Limits of Forward Guidance. FRB of Chicago Working Paper 2019-03. https://doi.org/10.21033/wp-2019-03.CrossRefGoogle Scholar
Carlstrom, C. T., Fuerst, T. S. and Paustian, M. (2015) Inflation and output in new keynesian models with a transient interest rate peg. Journal of Monetary Economics 76 (November), 230243. https://doi.org/10.1016/j.jmoneco.2015.09.004.CrossRefGoogle Scholar
Christiano, L. J., Eichenbaum, M. and Evans, C. L. (2005) Nominal rigidities and the dynamic effects of a shock to monetary policy. Journal of Political Economy 113(1), 145. https://doi.org/10.1086/426038.CrossRefGoogle Scholar
Clark, T. E. (2009) Is the great moderation over? An empirical analysis. Federal Reserve Bank of Kansas City Economic Review (Fourth Quarter), 5–42. https://bit.ly/35Kef29.Google Scholar
Coibion, O. and Gorodnichenko, Y. (2012) What can survey forecasts tell us about information rigidities? Journal of Political Economy 120(1), 116159. https://doi.org/10.1086/665662.CrossRefGoogle Scholar
Coibion, O. and Gorodnichenko, Y. (2015) Information rigidity and the expectations formation process: A simple framework and new facts. American Economic Review 105(8), 26442678. https://doi.org/10.1257/aer.20110306.CrossRefGoogle Scholar
Cole, S. J. (2020a) Learning and the effectiveness of central bank forward guidance. Journal of Money, Credit and Banking. https://bit.ly/2QWWCIl.10.1111/jmcb.12696CrossRefGoogle Scholar
Cole, S. J. (2020b) The limits of central bank forward guidance under learning. International Journal of Central Banking. https://bit.ly/2qI3nmP.Google Scholar
Cole, S. J. and Milani, F. (2017) The misspecification of expectations in new Keynesian models: A DSGE-VAR approach. Macroeconomic Dynamics 23(3), 9741007. https://doi.org/10.1017/s1365100517000104.CrossRefGoogle Scholar
Contessi, S. and Li, L. (2013) Forward guidance 101A: A roadmap of the U.S. experience. Federal Reserve Bank of St. Louis Economic Synopses 25, 13. https://bit.ly/2OWafoz.Google Scholar
Czudaj, R. L. and Beckmann, J. (2018) Monetary policy shocks, expectations, and information rigidities. Economic Inquiry 56(4), 21582176. https://doi.org/10.1111/ecin.12587.Google Scholar
CÚrdia, V., Ferrero, A., Ng, G. C. and Tambalotti, A. (2015) Has U.S. monetary policy tracked the efficient interest rate? Journal of Monetary Economics 70, 7283. https://doi.org/10.1016/j.jmoneco.2014.09.004.CrossRefGoogle Scholar
De Graeve, F., Ilbas, P. and Wouters, R. (2014) Forward Guidance and Long Term Interest Rates: Inspecting the Mechanism. Sveriges Riksbank Working Paper No. 292. https://www.econstor.eu/handle/10419/129709.Google Scholar
Del Negro, M., Giannoni, M. P. and Patterson, C. (2012) The Forward Guidance Puzzle. FRB of New York Staff Report No. 574. http://dx.doi.org/10.2139/ssrn.2163750.CrossRefGoogle Scholar
Dennis, R. (2004) Specifying and Estimating New Keynesian Models With Instrument Rules and Optimal Monetary Policies. FRB of San Francisco Working Paper Series 2004–17. https://doi.org/10.24148/wp2004-17.CrossRefGoogle Scholar
Doehr, R. and Martínez-García, E. (2015) Monetary Policy Expectations and Economic Fluctuations at the Zero Lower Bound. Globalization and Monetary Policy Institute Working Paper no. 240. https://doi.org/10.24149/gwp240.CrossRefGoogle Scholar
Dong, B. and Young, E. R. (2019) Forward Guidance and Credible Monetary Policy. SSRN Working Paper No. 2685987. http://dx.doi.org/10.2139/ssrn.2685987.CrossRefGoogle Scholar
Eggertsson, G. B. and Woodford, M. (2003) The zero bound on interest rates and optimal monetary policy. Brookings Papers on Economic Activity 2003(1), 139211. Project MUSE. https://doi.org/10.1353/eca.2003.0010.CrossRefGoogle Scholar
Eusepi, S. and Preston, B. (2010) Central bank communication and expectations stabilization. American Economic Journal: Macroeconomics 2(3), 235271. https://doi.org/10.1257/mac.2.3.235.Google Scholar
Ferrero, G. and Secchi, A. (2009) The Announcement of Monetary Policy Intentions. Temi di discussione (Economic working papers) 720. Bank of Italy, Economic Research and International Relations Area. http://dx.doi.org/10.2139/ssrn.1523254.CrossRefGoogle Scholar
Ferrero, G. and Secchi, A. (2010) Central Banks’ Macroeconomic Projections and Learning. Bank of Italy Temi di Discussione (Working Paper) No. 782. Bank of Italy, Economic Research and International Relations Area. http://dx.doi.org/10.2139/ssrn.1803168.CrossRefGoogle Scholar
FRB of Philadelphia (2019) Survey of Professional Forecasters: Documentation. Last Update: October 16, 2019. https://bit.ly/37S2jgy.Google Scholar
Gaspar, V., Smets, F., and Vestin, D. (2006) Adaptive learning, persistence, and optimal monetary policy. Journal of the European Economic Association 4(2–3), 376385. https://doi.org/10.1162/jeea.2006.4.2-3.376.CrossRefGoogle Scholar
Gaspar, V., Smets, F. and Vestin, D. (2010) Inflation expectations, adaptive learning and optimal monetary policy. In: Friedman, B. M. and Woodford, M. (eds.), Handbook of Monetary Economics, Volume 3, Chapter 19, pp. 10551095. Elsevier B.V. https://doi.org/10.1016/b978-0-444-53454-5.00007-4.CrossRefGoogle Scholar
Gauss, E. (2015) Adaptive Learning, Heterogeneous Expectations and Forward Guidance. Technical Report, Mimeo. Ursinus College. https://bit.ly/2rBXzuT.Google Scholar
Gersbach, H., Hahn, V. and Liu, Y. (2019) Forward guidance contracts. Macroeconomic Dynamics 23(8), 33863423. https://doi.org/10.1017/S1365100518000093 CrossRefGoogle Scholar
Giannoni, M. P. and Woodford, M. (2004) Optimal inflation-targeting rules. In: Bernanke, B. S. and Woodford, M. (eds.), The Inflation-Targeting Debate, Chapter 3, pp. 93–172. Chicago: Chicago Scholarship Online.10.7208/chicago/9780226044736.003.0004CrossRefGoogle Scholar
Goodfriend, M. and King, R. G. (2016) Review of the Riksbank’s Monetary Policy 2010-2015. Sveriges riksdag. https://data.riksdagen.se/dokument/RFR-201516-RFR7.pdf.Google Scholar
Goy, G., Hommes, C. H. and Mavromatis, K. (2018) Forward Guidance and the Role of Central Bank Credibility under Heterogeneous Beliefs. De Nederlandsche Bank Working Paper No. 614. https://doi.org/10.2139/ssrn.3296214.CrossRefGoogle Scholar
Haberis, A., Harrison, R. and Waldron, M. (2014) Transitory Interest-Rate Pegs Under Imperfect Credibility. LSE Research Online Documents on Economics 86335. London School of Economics and Political Science, LSE Library. http://eprints.lse.ac.uk/86335/.Google Scholar
Haberis, A., Harrison, R. and Waldron, M. (2019). Uncertain policy promises. European Economic Review 111, 459474. https://doi.org/10.1016/j.euroecorev.2018.11.003.CrossRefGoogle Scholar
Hansen, L. and Sargent, T. (1980) Formulating and estimating dynamic linear rational expectations models. Journal of Economic Dynamics and Control 2(1), 746. https://doi.org/10.1016/0165-1889(80)90049-4.CrossRefGoogle Scholar
Honkapohja, S. and Mitra, K. (2005) Performance of inflation targeting based on constant interest rate projections. Journal of Economic Dynamics and Control 29(11), 18671892. https://doi.org/10.1016/j.jedc.2005.06.006.CrossRefGoogle Scholar
Honkapohja, S. and Mitra, K. (2020) Price level targeting with evolving credibility. Journal of Monetary Economics 116(December), 88103. https://doi.org/10.1016/j.jmoneco.2019.09.009.CrossRefGoogle Scholar
Hubert, P. (2014) FOMC forecasts as a focal point for private expectations. Journal of Money, Credit and Banking 46(7), 13811420. https://doi.org/10.1111/jmcb.12142.CrossRefGoogle Scholar
Hubert, P. (2015a) Do central bank forecasts influence private agents? Forecasting performance versus signals. Journal of Money, Credit and Banking 47(4), 771789. https://doi.org/10.1111/jmcb.12227.CrossRefGoogle Scholar
Hubert, P. (2015b) The influence and policy signalling role of FOMC forecasts. Oxford Bulletin of Economics and Statistics 77(5), 655680. https://doi.org/10.1111/obes.12093.CrossRefGoogle Scholar
Hughes Hallett, A. and Acocella, N. (2018) Stabilization and commitment: Forward guidance in economies with rational expectations. Macroeconomic Dynamics 22(1), 122134. https://doi.org/10.1017/S136510051600002X.CrossRefGoogle Scholar
Kiley, M. T. (2016) Policy paradoxes in the new Keynesian model. Review of Economic Dynamics 21(July), 115. https://doi.org/10.1016/j.red.2016.03.002.CrossRefGoogle Scholar
Kydland, F. E. and Prescott, E. C. (1977) Rules rather than discretion: The inconsistency of optimal plans. Journal of Political Economy 85(3), 473492.10.1086/260580CrossRefGoogle Scholar
Laséen, S. and Svensson, L. E. O. (2011) Anticipated alternative policy rate paths in policy simulations. International Journal of Central Banking 7(3), 135. https://www.ijcb.org/journal/ijcb11q3a1.htm.Google Scholar
Lindsey, D. E. (2003) A Modern History of FOMC Communication: 1975-2002. Board of Governors of the Federal Reserve System Memorandum. https://bit.ly/2OvZz10.Google Scholar
Martínez-García, E. and SØndergaard, J. (2013) Investment and real exchange rates in sticky price models. Macroeconomic Dynamics 17(2), 195234. https://doi.org/10.1017/s1365100511000095.CrossRefGoogle Scholar
Martínez-García, E. (2018) Modeling time-variation over the business cycle (1960–2017): An international perspective. Studies in Nonlinear Dynamics and Econometrics 22(5), 125. https://doi.org/10.1515/snde-2017-0101.Google Scholar
Martínez-García, E. (2021) Get the lowdown: The international side of the fall in the U.S. natural rate of interest. Economic Modelling 100(July), 105486. https://doi.org/10.1016/j.econmod.2021.03.005.CrossRefGoogle Scholar
McKay, A., Nakamura, E. and Steinsson, J. (2016) The power of forward guidance revisited. American Economic Review 106(10), 31333158. https://doi.org/10.1257/aer.20150063.CrossRefGoogle Scholar
Milani, F. (2007) Expectations, learning and macroeconomic persistence. Journal of Monetary Economics 54(7), 20652082. https://doi.org/10.1016/j.jmoneco.2006.11.007.CrossRefGoogle Scholar
Nakata, T. and Sunakawa, T. (2019) Credible Forward Guidance. Finance and Economics Discussion Series 2019-037. Washington: Board of Governors of the Federal Reserve System. https://doi.org/10.17016/FEDS.2019.037.CrossRefGoogle Scholar
Orphanides, A. and Williams, J. C. (2004) Imperfect knowledge, inflation expectations, and monetary policy. In: Bernanke, B. S. and Woodford, M. (eds.), The Inflation-Targeting Debate, Chapter 5, pp. 201–245. Chicago: Chicago Scholarship Online. https://doi.org/10.7208/chicago/9780226044736.001.0001.CrossRefGoogle Scholar
Orphanides, A. and Williams, J. C. (2007) Robust monetary policy with imperfect knowledge. Journal of Monetary Economics 54(5), 14061435. https://doi.org/10.1016/j.jmoneco.2007.06.005.CrossRefGoogle Scholar
Osborne, M. J. and Rubinstein, A. (1994) A Course in Game Theory. MIT Press.Google Scholar
Park, K. (2018) Central Bank Credibility and Monetary Policy. Economic Research Institute Working Paper 2018-45. Bank of Korea. https://bit.ly/2rDaXPm.10.2139/ssrn.3306035CrossRefGoogle Scholar
Schmitt-Grohé, S. and Uribe, M. (2012) What’s news in business cycles. Econometrica 80(6), 27332764. https://doi.org/10.3982/ecta8050.Google Scholar
Sims, C. A. (2002) Solving linear rational expectations models. Computational Economics 20(1), 120. https://doi.org/10.1023/A:1020517101123.CrossRefGoogle Scholar
Smets, F. and Wouters, R. (2007) Shocks and frictions in U.S. business cycles: A Bayesian DSGE approach. American Economic Review 97(3), 586606. https://doi.org/10.1257/aer.97.3.586.CrossRefGoogle Scholar
Stock, J. H. and Watson, M. W. (2001) Vector autoregressions. Journal of Economic Perspectives 15(4), 101115. https://doi.org/10.1257/jep.15.4.101.CrossRefGoogle Scholar
Swanson, E. T. (2018) The federal reserve is not very constrained by the lower bound on nominal interest rates. Brookings Papers on Economic Activity 2018(2), 555572. Project MUSE. https://doi.org/10.1353/eca.2018.0015.CrossRefGoogle Scholar
Taylor, J. B. (1993) Discretion versus policy rules in practice. Carnegie-Rochester Conference Series on Public Policy 39, 195214. https://doi.org/10.1016/0167-2231(93)90009-l.CrossRefGoogle Scholar
Williams, J. C. (2013) Will unconventional policy be the new normal? FRBSF Economic Letter 2013-29. https://bit.ly/2P328Xx.Google Scholar
Woodford, M. (2003) Interest and Prices. Foundations of a Theory of Monetary Policy. Princeton, New Jersey: Princeton University Press.Google Scholar
Woodford, M. (2005) Central-Bank Communication and Policy Effectiveness. Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City. ‘The Greenspan Era: Lessons for the Future’. https://doi.org/10.3386/w11898.CrossRefGoogle Scholar
Wynne, M. A. (2013) A short history of FOMC communication. Federal Reserve Bank of Dallas Economic Letter 8, 14. https://bit.ly/33yRuwO.Google Scholar
Yellen, J. L. (2006) Enhancing fed credibility. FRBSF Economic Letter. Federal Reserve Bank of San Francisco, issue mar17. https://bit.ly/3qDYhkZ.Google Scholar
Yun, T. (1996) Nominal price rigidity, money supply endogeneity, and business cycles. Journal of Monetary Economics 37(2), 345370. https://doi.org/10.1016/s0304-3932(96)90040-9.CrossRefGoogle Scholar
1
Cited by

Save article to Kindle

To save this article to your Kindle, first ensure coreplatform@cambridge.org is added to your Approved Personal Document E-mail List under your Personal Document Settings on the Manage Your Content and Devices page of your Amazon account. Then enter the ‘name’ part of your Kindle email address below. Find out more about saving to your Kindle.

Note you can select to save to either the @free.kindle.com or @kindle.com variations. ‘@free.kindle.com’ emails are free but can only be saved to your device when it is connected to wi-fi. ‘@kindle.com’ emails can be delivered even when you are not connected to wi-fi, but note that service fees apply.

Find out more about the Kindle Personal Document Service.

The effect of central bank credibility on forward guidance in an estimated New Keynesian model
Available formats
×

Save article to Dropbox

To save this article to your Dropbox account, please select one or more formats and confirm that you agree to abide by our usage policies. If this is the first time you used this feature, you will be asked to authorise Cambridge Core to connect with your Dropbox account. Find out more about saving content to Dropbox.

The effect of central bank credibility on forward guidance in an estimated New Keynesian model
Available formats
×

Save article to Google Drive

To save this article to your Google Drive account, please select one or more formats and confirm that you agree to abide by our usage policies. If this is the first time you used this feature, you will be asked to authorise Cambridge Core to connect with your Google Drive account. Find out more about saving content to Google Drive.

The effect of central bank credibility on forward guidance in an estimated New Keynesian model
Available formats
×
×

Reply to: Submit a response

Please enter your response.

Your details

Please enter a valid email address.

Conflicting interests

Do you have any conflicting interests? *