Abstract
Central banks are increasingly communicating their economic outlook in an effort to manage the public and financial market participants’ expectations. We provide original causal evidence that the information communicated and the assumptions underlying a central bank’s projection can matter for expectation formation and aggregate stability. Using a between-subject design, we systematically vary the central bank’s projected forecasts in an experimental macroeconomy where subjects are incentivized to forecast the output gap and inflation. Without projections, subjects exhibit a wide range of heuristics, with the modal heuristic involving a significant backward-looking component. Ex-Ante Rational dual projections of the output gap and inflation significantly reduce the number of subjects’ using backward-looking heuristics and nudge expectations in the direction of the rational expectations equilibrium. Ex-Ante Rational interest rate projections are cognitively challenging to employ and have limited effects on the distribution of heuristics. Adaptive dual projections generate unintended inflation volatility by inducing boundedly-rational forecasters to employ the projection and model-consistent forecasters to utilize the projection as a proxy for aggregate expectations. All projections reduce output gap disagreement but increase inflation disagreement. Central bank credibility is significantly diminished when the central bank makes larger forecast errors when communicating a relatively more complex projection. Our findings suggest that inflation-targeting central banks should strategically ignore agents’ irrationalities when constructing their projections and communicate easy-to-process information.
Highlights
The economy is highly complex with many moving parts
We first evaluate the aggregatelevel data to identify the effects of projections on economic stability and macroeconomic dynamics
While a combination of rational and backward-looking expectations are well-supported by survey and experimental data, our findings suggest that central banks interested in maintaining inflation stability in the presence of demand shocks should strategically communicate projections based solely on rational expectations
Summary
The economy is highly complex with many moving parts. It can be very challenging for the average person, with limited cognitive capacity and attention, to accurately forecast how it will evolve. As the variability of shocks increases, the ease and value of using the projection decreases, and subjects instead rely on adaptive forecasting heuristics These results suggest that policymakers cannot take for granted that private agents can infer the implied path of inflation and the output gap from an interest rate projection. In a closely related paper to ours, Jain and Sutherland (2018) construct an original panel data set of 23 countries to estimate the effects of numerous central bank projections and forward guidance on privatesector forecast dispersion and accuracy They find that macroeconomic central bank projections are generally ineffective at reducing private-sector forecast dispersion and forecast errors about inflation and output growth. Our findings provide original empirical support for the policy recommendation that strict inflation-targeting central banks disregard the public’s adaptive forecasting heuristics when designing their communication strategy.
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