Central bank transparency, private information and the predictability of monetary policy in the financial markets : theoretical, experimental and empirical evidence

Abstract

Central banks worldwide have become considerably more communicative about their policies and forecasts. An important reason is that democratic societies expect such transparency from public institutions. Central bankers, supported by a significant body of empirical research, also believe that sharing information has economic benefits. Regarding the financial markets in particular, communication is seen as a way to improve the predictability of monetary policy, thereby lowering market volatility and contributing to a more stable economy. A potential downside of central banks providing costless public information is that financial market participants may be less inclined to invest in private information. This doctoral thesis explores this possibility with theoretical, experimental and empirical evidence. In a rational expectations asset market model where traders have the option of acquiring a signal of fixed cost and precision, it is indeed possible that public information crowds out private information. The result is a financial market that is less able to predict future monetary policy and interest rates that are more volatile. Experimental research, rare in the area of monetary policy, shows that these results can be reproduced in a laboratory asset market closely based on the theoretical model. Empirical evidence, however, suggests that so far transparency has actually helped to improve the ability of financial markets to anticipate monetary policy. Studying US Fed funds futures shows that new communication policies in the mid-90s and mid-00s led to better aligned expectations of monetary policy, after correcting for time varying risk premia. Statistical analysis of the relationship between the Dincer and Eichengreen index of transparency and money market interest rate forecasts for 24 countries (much more than earlier work) shows that higher transparency improves accuracy and lowers interest rate volatility. So, while theoretically central bank communication can crowd out private information and make markets less able to predict monetary policy, so far the practical application of transparency has done the opposite. Nevertheless, as central bankers reveal even more information, they should monitor whether other voices reach the financial markets rather than just their own, lest this inhibits markets from providing the best possible estimate of future policy.