2015 Series • No. 15–8
Research Department Working Papers
Uncertainty and the Signaling Channel of Monetary Policy 
A growing body of evidence supports the view that monetary policy actions communicate information about the state of the economy to an imperfectly informed public. Therefore, it is important for policymakers to understand the implications of this signaling channel for optimal policy as well as for the value of central bank communication. This paper studies, both theoretically and empirically, a setting where such a monetary policy signaling channel arises because the policymaker has more information about economic fundamentals than private agents have. In this environment, policy actions taken in response to fundamentals provide a signal to rational private agents about those fundamentals.
Key Findings
- For a given monetary policy, for the signaling channel to produce positive responses of inflation and output forecasts to interest rate increases, the monetary policy response to demand shocks must not be strong enough to fully offset the effects of those shocks and the interest rate must be a strong enough signal of demand. This latter condition is satisfied in the author's setup when uncertainty about demand is high relative to uncertainty about the policy target.
- The signaling channel alters the inflation-output tradeoff by creating a link between interest rate accommodation and inflation expectations.
- The type of information that is private to the central bank can matter crucially for results. One key distinguishing factor is the direction of the relationship between policy actions and inflation expectations that is generated by the signaling effect. When the interest rate is a signal about the output or inflation target, a discretionary policymaker is led to maintain more stable inflation. However, when the interest rate serves, instead, as a signal about markup shocks, then a policymaker who cannot commit will choose to be more accommodative toward markup shocks relative to the perfect information benchmark, thus moving the equilibrium even further from the optimum under commitment policy. This difference in the effect of signaling on optimal interest rate setting also leads to differences in the tradeoffs regarding communication. In particular, transparency about markup shocks can be welfare-improving when the signaling channel is present.
- The signaling channel is supported empirically by evidence that inflation forecasts respond more positively to surprise interest rate increases when forecast uncertainty is high.
Implications
A central bank may wish to withhold information about output or inflation targets because allowing the interest rate to serve as a signal about either of these targets links interest rate accommodation and inflation expectations in a way that leads a discretionary policymaker to maintain more stable inflation.
It may be beneficial for there to be more direct communication about markup shocks because when the interest rate signals information regarding markup shocks, a discretionary policymaker is led to be overly accommodative toward these shocks. This stands in contrast to the case where interest rates are not a signal about markup shocks.
When interest rates are a signal of economic fundamentals, direct communication is not synonymous with agents' information in equilibrium. One example of this is that, in a setting with a time-varying inflation target, it is beneficial for private agents to be fully informed about this target. Despite this, it is best for the central bank to design a communication policy that allows agents to perfectly infer the inflation target from the interest rate since allowing the interest rate to be an indirect signal of this target results in optimal discretionary interest rate policy that maintains greater inflation stabilization.
Abstract
This paper studies an environment where policy actions provide a signal of fundamentals to imperfectly informed agents. Closed-form solutions for optimal discretionary policy illustrate that this signaling channel can lead policymakers to maintain more stable inflation by linking policy accommodation to higher inflation expectations. This disciplining effect creates a benefit of central bank intransparency. The presence of this disciplining effect depends on the type of information signaled by interest rates and uncertainty levels determine its magnitude. The signaling channel is supported empirically by evidence that inflation forecasts respond more positively to surprise interest rate increases when forecast uncertainty is high.