Central bank monetary policy signaling

Abstract

Central banks constantly communicate about monetary policy, often sending signals about their future policy intentions. Indeed, actual changes in policy rates are rarely a surprise because they have been telegraphed in advance. Financial markets respond to these signals by changing expected future interest rates. This was the explicit intention of Odyssean forward guidance at the effective lower bound and the success of this instrument suggests that central banks have some capacity to commit to future policy action. This paper develops a model in which the central bank can send a signal about its oneperiod-ahead policy rate and then pays a reputational cost of deviating from this signal ex post. Although the inherited signal constrains the central bank in how far it will be willing to adjust the current policy rate to respond to a new shock, it gains a powerful new instrument through the signal it can send. The paper shows that this signaling strategy is welfare improving in the face of markup shocks and supports a "duration" over "peak" strategy in responding to such shocks. This model is consistent with certain empirical monetary policy facts: the presence of path and target shocks in monetary surprises, and the auto-correlation of nominal interest rates.

Keywords: monetary policy, communication, central bank