Globalization Institute Working Paper
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. Forward guidance and the credibility of the central bank are uniquely modeled by utilizing a game-theoretic evolutionary framework. 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. (2) If a central bank is perceived as less credible, anticipation effects are attenuated and, accordingly, output and inflation do not respond as favorably to forward guidance announcements. (3) Imperfect credibility and forward guidance are an important aspect 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. (4) Imperfect central bank 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.