Coordinating expectations through central bank projections

Area of Science:

• Economics
• Behavioral Economics
• Macroeconomic Policy

Background:

• Central banks increasingly use economic outlook communication to manage expectations.
• Understanding how communicated information affects public and market expectations is crucial for aggregate stability.

Purpose of the Study:

• To provide causal evidence on how central bank communication, specifically projection content and assumptions, influences expectation formation and economic stability.
• To analyze the effects of different types of central bank projections (Ex-Ante Rational dual, Ex-Ante Rational interest rate, Adaptive dual) on economic forecasting behavior.

Main Methods:

• Utilized a between-subject experimental design in a simulated macroeconomy.
• Incentivized subjects to forecast the output gap and inflation under varying central bank projection conditions.
• Analyzed the heuristics employed by subjects and their impact on expectation formation.

Main Results:

• Ex-Ante Rational dual projections reduced backward-looking heuristics and moved expectations towards the rational expectations equilibrium.
• Adaptive dual projections led to unintended inflation volatility.
• All projection types reduced output gap disagreement but increased inflation disagreement.
• Central bank credibility decreased with larger forecast errors, especially for complex projections.

Conclusions:

• Central bank communication strategies significantly influence economic expectations and stability.
• Simpler, easy-to-process information is more effective for managing expectations and avoiding volatility.
• Inflation-targeting central banks should consider cognitive limitations and simplify communication for better outcomes.