The Forward Guidance Puzzle and Anchored Inflation Expectations

In recent years, central banks have turned to forward guidance as a key tool of monetary policy. However, standard DSGE models overestimate the impact of forward guidance on the economy, a phenomenon known as the “forward guidance puzzle.” In the model employed, the reaction of firms to a central bank’s announcements depends on the degree of anchoring of inflation expecta- tions. When firms do not revise their forecasts much in response to inflation surprises, the effects of forward guidance shocks are attenuated. Furthermore, an increase in the Taylor rule coefficients implies a faster reversion of inflation and output to their steady state levels, thus resulting in more anchored inflation expectations and dampened effects of forward guidance announcements. How- ever, the central bank's exclusive focus on price stability eliminates forward guidance effects. This paper also studies the dependence of forward guidance on fiscal policy, which arises in a non- Ricardian economy. We show that the initial effects of the central bank’s announcements become considerably stronger when steady state debt is positive, whereas a stronger reaction of fiscal policy to debt fluctuations attenuates the power of forward guidance.