Coordinating expectations through central bank projections
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Coordinating expectations through central bank projections Fatemeh Mokhtarzadeh1 · Luba Petersen2 Received: 8 December 2017 / Revised: 14 June 2020 / Accepted: 22 September 2020 © The Author(s) 2020
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 backwardlooking 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. Keywords Expectations · Monetary policy · Projections · Communication · Credibility · Laboratory experiment · Experimental macroeconomics JEL Classification C9 · D84 · E52 · E58 Electronic supplementary material The online version of this article (https://doi.org/10.1007/s1068 3-020-09684-6) contains supplementary material, which is available to authorized users. * Luba Petersen [email protected] Extended author information available on the last page of the article
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F. Mokhtarzadeh, L. Petersen
1 Introduction 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. To ease this cognitive burden, guide expectations, and improve monetary policy efficacy, which operates largely through an expectations channel, central banks have become increasingly transparent about their objectives, future policies, and their outlook on the future. Many central banks publish a combination of projections about future GDP, GDP growth, CPI, and their policy rates. The Reserve Ban
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