The Forward Guidance Puzzle and Anchored Inflation Expectations

In recent years, central banks have turned to forward guidance as a key tool of monetary policy. However, standard DSGE models overestimate the impact of forward guidance on the economy, a phenomenon known as the “forward guidance puzzle.” In the model employed, the reaction of firms to a central bank’s announcements depends on the degree of anchoring of inflation expectations. When firms do not revise their forecasts much in response to inflation surprises, the effects of forward guidance shocks are attenuated. Furthermore, an increase in the Taylor rule coefficients implies a faster reversion of inflation and output to their steady state levels, thus resulting in more anchored inflation expectations and dampened effects of forward guidance announcements. However, the central bank's exclusive focus on price stability eliminates forward guidance effects. This paper also studies the dependence of forward guidance on fiscal policy, which arises in a nonRicardian economy. We show that the initial effects of the central bank’s announcements become considerably stronger when steady state debt is positive, whereas a stronger reaction of fiscal policy to debt fluctuations attenuates the power of forward guidance.