Central Bank Forward Guidance and the Signal Value of Market Prices

9 Pages Posted: 25 Jan 2018

See all articles by Stephen Morris

Stephen Morris

Princeton University - Department of Economics

Hyun Song Shin

Bank for International Settlements (BIS)

Date Written: January 2018

Abstract

Focus The paper examines the relationship between monetary policy and market prices through the lens of central bank communication. Central bankers use forward guidance to steer market expectations of future monetary policy moves. At the same time, they rely on market prices to gauge the likely path of the economy and the appropriate stance of monetary policy. This two-way flow between market prices and forward guidance can create a circularity, and raises questions on how best to read market signals without distorting those same prices.

Contribution The research is timely given the increasing importance of communication as a tool for central banks, especially since policy rates have been pushed down to their feasible lower limits. Policymakers are giving more speeches, holding more news conferences and embracing new communication channels on social media. They are also paying more attention to signals from financial markets. One example is market expectations of future inflation, also detailed in the speech "Can central banks talk too much?". This paper builds on previous theoretical contributions to construct a self-contained quantitative analysis of central bank communication and market prices. It raises important questions and provides insights on the effectiveness and design of forward guidance.

Findings The analysis suggests that relying less on market signals increases the effectiveness of central bank communication. In their eagerness to correctly anticipate policy moves, market participants risk giving too much weight to central bankers' utterances and not enough to assessing economic data. If central bankers, in turn, trust markets to guide their actions, they may end up creating a feedback loop that cancels out the value of the very market signals they rely on. In this circular relationship, market outcomes reflect central bank actions, which in turn reflect market outcomes.

Keywords: central bank communication, market expectations, crowding out

JEL Classification: D82, E43, E58

Suggested Citation

Morris, Stephen Edward and Shin, Hyun Song, Central Bank Forward Guidance and the Signal Value of Market Prices (January 2018). BIS Working Paper No. 692. Available at SSRN: https://ssrn.com/abstract=3107844

Stephen Edward Morris (Contact Author)

Princeton University - Department of Economics ( email )

Princeton, NJ 08544-1021
United States

Hyun Song Shin

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

HOME PAGE: http://www.bis.org/author/hyun_song_shin.htm

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