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

Abstract

This paper examines the effectiveness of 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 guidance announcements is relatively high, which indicates a degree of 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 guidance announcements. (3) Imperfect credibility and 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 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 guidance announcements.