Working Papers
Forward Guidance for Skeptical Markets
Abstract: This paper develops a theory of forward guidance that captures two key features of central bank communication: announcements are not fully state-contingent, and the private sector is wary of policy mistakes. The central bank tailors announcements along two dimensions: (i) vagueness—how tightly the announcement constrains future policy; and (ii) data dependence—how aggressively future policy responds to a public signal of the economy. Three main lessons emerge. First, uncertainty affects communication differently depending on its source: uncertainty about both demand and cost-push shocks increases optimal vagueness, but only demand-side uncertainty increases the optimal degree of data dependence. Second, strict rules are costly: fully precise guidance entails sizable welfare losses that grow with the steepness of the Phillips curve. Third, because of the stabilizing role of announcements, optimal forward guidance differs sharply from simply communicating the best forecast of the future optimal policy rate (Delphic guidance).