Central Bank Policy Rate Guidance and Financial Market Functioning

Abstract

Central bank communication has changed dramatically over the past decade, with some central banks providing guidance about or explicit forecasts of likely future policy rates. One frequently made argument against the provision by central banks of such guidance or forecasts is that it runs the risk of impairing market functioning. In this paper, we evaluate the behavior of financial markets in the United States, the euro area and New Zealand in light of the communication strategies of central banks, in order to assess whether the provision of policy rate guidance by central banks impairs market functioning. While we find evidence that central bank policy rate forecasts influence market prices in New Zealand, we find no evidence that such guidance or forecasts impair market functioning in the United States, the euro area or New Zealand. The results suggest that the risk of impairing market functioning is not a strong argument against central banks' provision of policy rate guidance or forecasts.

Keywords: Central bank communication, policy rate forecasts, financial market functioning

JEL Classification: E52, E58, G14