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Living Up to Expectations: The Effectiveness of Forward Guidance and Inflation Dynamics Post-Global Financial Crisis

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Abstract

This paper studies the effectiveness of forward guidance when central banks face private agents with heterogeneous expectations allowing for a degree of bounded rationality. Exploiting unique survey-based measures of expected inflation, output growth and interest rates, we estimate a small-scale New Keynesian model with forward guidance shocks for the United States and the other G7 countries plus Spain. We find that the share of fully-informed rational expectations (FIRE) agents in aggregate expectations is similar for the U.S., the U.K., Germany and other major advanced economies (albeit far from one); however, Japan’s share is much lower. For each country, the estimate of the share of FIRE agents has declined over time as VAR-based expectations—the heuristic approach assumed under bounded rationality—became more prominent in explaining the more recent data. Forward guidance has correspondingly grown less effective. In a counterfactual analysis, we document that, in the wake of the global financial crisis, inflation would have been significantly higher and the zero lower bound on short-term interest rates much less of a constraint had the public fully incorporated central banks’ forward guidance statements as FIRE agents do. Moreover, inflation would have declined more, and somewhat faster, in the wake of the post-COVID-19 inflation surge as well.

Suggested Citation

  • Stephen J. Cole & Enrique Martínez García & Eric Sims, 2023. "Living Up to Expectations: The Effectiveness of Forward Guidance and Inflation Dynamics Post-Global Financial Crisis," Globalization Institute Working Papers 424, Federal Reserve Bank of Dallas, revised 03 Apr 2025.
  • Handle: RePEc:fip:feddgw:97039
    DOI: 10.24149/gwp424r1
    Note: Previous version was titled, "Living Up to Expectations: Central Bank Credibility, the Effectiveness of Forward Guidance and Inflation Dynamics Post-Global Financial Crisis."
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    References listed on IDEAS

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    Cited by:

    1. Donald W. K. Andrews & Ming Li, 2024. "Inference in a Stationary/Nonstationary Autoregressive Time-Varying-Parameter Model," Cowles Foundation Discussion Papers 2389, Cowles Foundation for Research in Economics, Yale University.

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    More about this item

    Keywords

    forward guidance; monetary policy; heterogeneous expectations; expectations formation; VAR-based forecasting;
    All these keywords.

    JEL classification:

    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • E60 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - General
    • P52 - Political Economy and Comparative Economic Systems - - Comparative Economic Systems - - - Comparative Studies of Particular Economies

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