Coordinating expectations through central bank projections

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.

Central bank communication that works: Lessons from lab experiments

“…Related experiments have explored communication in conjunction with conventional policy options, such as ination targets under single and dual mandates (Cornand and M'baye, 2018) and time-varying ination targets at the zero lower bound (Arifovic and Petersen, 2017). Others have studied how macroeconomic forecasts can be managed through various types of central bank projections (Mokhtarzadeh and Petersen, 2017) and macroeconomic literacy training (Mirdamadi and Petersen, 2018). We add to this literature by incorporat-…”

“…Second, it is more likely that subjects will incorporate information about future ination and output gap into forecasts than they will interest rate information, as the latter requires more cognitive processing. Survey evidence (Jain and Sutherland, 2018) and experimental evidence (Mokhtarzadeh and Petersen, 2017) nd that forecast dispersion decreases more consistently with ination and output gap projections than with interest rate projections.…”

Central Bank Communication that Works: Lessons from Lab Experiments

“…Related experiments have explored communication in conjunction with conventional policy options, such as ination targets under single and dual mandates (Cornand and M'baye, 2018) and time-varying ination targets at the zero lower bound (Arifovic and Petersen, 2017). Others have studied how macroeconomic forecasts can be managed through various types of central bank projections (Mokhtarzadeh and Petersen, 2017) and macroeconomic literacy training (Mirdamadi and Petersen, 2018). We add to this literature by incorporat-…”

Should central banks communicate uncertainty in their projections?

“…One exception is Rholes and Sekhposyan (2020) who show that short-term yields respond at least as strongly to revisions of the second-and third-moments of the BoE's density forecasts as they do to revisions of the first-moment of the same density forecasts. 1 In closely related experimental work, Mokhtarzadeh and Petersen (2018) show that density projections (that present both the point forecast and a confidence interval) are effective at managing expectations if they are relevant and easy to understand. Their findings, however, do not isolate the effect of density forecasts from the point projections.…”