Controlling inflation with central bank communication

What determines the stochastic path of inflation? We study this question in a monetary economy featuring imperfect information and rational expectations. The central bank follows an inflation targeting rule and communicates noisy information about the future state of the economy to market participants through its public forecasts of inflation and output. Agents update their beliefs in a Bayesian way and infer the central bank’s noisy signal. Through this mechanism, the central bank’s forecasts shape market expectations of economic conditions, imposing additional restrictions on the equilibrium and ultimately determining the stochastic path of inflation. Importantly, in the absence of explicit guidance provided by public forecasts, the central bank loses control over its main target under the inflation targeting policy.