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17.05.2012
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Central Banking and the Design of Monetary Policy

Prof. Dr. Joachim Scheide & M.F. Tesfaselassie Ph.D.

This research project aimed to assess two important aspects of central bank design: (1) the effectiveness of central bank communication and (2) the conduct of monetary policy under uncertainty and active learning (with a focus on disinflation policy).

The theoretical studies on central bank communication focus on the welfare effects of communication when a central bank has (i) imperfect information about private sector inflation expectations or (ii) private information about the future state of the economy. The empirical studies focus on questions like: Do central bank announcements affect market expectations about the future path of monetary policy? Is the communication of the European Central Bank more credible/effective than the communication of the U.S. Federal Reserve?

In analyzing the above mentioned questions, the project used state of the art models of the macroeconomy and special data sets like the interest rate data from Eurobor futures market and central bank announcements.

The theoretical studies show that:

  1. The effect of advance disclosure of future shocks depends on the presence of uncertainty about policy targets when the shock occurs. With uncertainty about policy targets, disclosure is harmless to current outcomes owing to the strong dependence of inflation expectations on policy actions, which induces the central bank to focus exclusively on price stability. If the central bank's targets are common knowledge, disclosure of future shocks impairs stabilization of current inflation and output.
  2. Transparency about a central bank's forecasting procedures improves output stabilization. Also higher transparency increases optimal conservatism, as the benefits from higher transparency in terms of output stabilization are greater the more conservative is the central bank.
  3. The speed of disinflation is affected by learning considerations. Under active learning by the central bank it is optimal for inflation to stay between the levels implied by certainty equivalence and cautionary policy. This holds irrespective of the initial (steady state) level of inflation.
The empirical studies show that: 
  1. Two pieces of news systematically hit financial markets following Governing Council meetings: the central bank’s policy rate decision and the explanation of its monetary policy stance.
  2. The unexpected component of central bank communication has a significant and sizable impact on futures prices.
  3. The response of American long-term yields to the surprise component of the Fed's statements is significantly larger than the reaction of European long-term yields to the ECB's announcements. This result is intimately related to the higher transparency of U.S. Fed statements compared to ECB statements rather than to the different institutional mandate of the two central banks.
  4. The Fed has been more able to move the European interest rates of all maturities than the ECB to move American rates. This finding is tied to the predominance of dollar fixed income assets rather than to an attempt of the ECB to mimic the Fed.

 

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