A model of market surprises

Working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 14 June 2007

Working Paper No. 327
By Lavan Mahadeva

This paper presents a theory to link improvements in transparency about monetary policy objectives to improvements in transparency about monetary policy actions and then to the conditional volatility of market expectations of policy rates. Crucially, policy announcements act not just as an instrument but also as a beacon that can potentially communicate information to agents about the policymakers’ reactions to shocks. When the objectives of policymakers are not made transparent, agents are more likely to interpret any accommodation to price shocks as indicating that policymakers are following their own unobserved suboptimal objectives. Policymakers in these regimes are therefore less inclined to be transparent in their explanations. Conversely when policy objectives are more clearly defined, policymakers become more transparent in their explanations too. Then, the less markets will be surprised by interest rate announcements. I show that happens at a diminishing rate: as transparency is improved further from already high levels, there is less of a reduction in the variance of market surprises. The reason is that agents know that they can rely more on the monetary policy beacon in very transparent regimes. Hence they become more active in their decision-making and policymakers take that extra sensitivity into account. The model illustrates the gains to having clearly defined policy objectives. It also explains how a continued occurrence of market surprises, after an initial large reduction, could be consistent with the greater transparency and more precisely formed inflation expectations.

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