Monetary policy signals: Seperating news from noise…

Interesting Bank of Canada Working Paper by Tatjana Dahlhaus and Luca Gambetti.

The authors look at Federal Reserve Monetary Policy signals. They find there is more noise than news:

The FOMC’s emergent use of guidance concerning future policy decisions since the 1990s suggests that monetary policy actions are anticipated to some extent. Agents receive signals from the central bank revealing new information (“news”) about the future path of the policy rate well before changes in the
rate occur, and adjust their expectations accordingly. Signals can be transmitted to the public via statements, press releases or speeches, for example. However, the signal may be disturbed by noise in the sense that agents do not receive a clear signal and, thus, do not understand or interpret the news

Therefore, agents observe only a noisy signal, which can be decomposed into a news shock (future or anticipated monetary policy shock) and a noise shock. The source of noise in monetary policy can be twofold. First, communication about future monetary policy by the central bank could be unclear; e.g., there could be ambiguity in words, sentences, or paragraphs. Second, agents may interpret the signal from the central bank incorrectly due to their preconceived notions about the central bank’s biases based on its track record, i.e., central bank credibility. As time passes, agents learn about past news shocks by
looking at the realized policy rate and can disentangle the real news from noise.

Modelling news and noise in monetary policy imposes a challenge for empirical analysis because standard vector autoregression (VAR) methods fail. Against this backdrop, we apply a non-standard structural VAR framework for monetary policy, which allows us to quantify the impacts of news and noise in monetary
policy communication. Our analysis uses US data over the period from 1994 to 2016.

We find the following: First, on average, US monetary policy signals contain more noise than news. Second, noise can be economically costly since it decreases output and prices. Third, noise affects financial markets by decreasing stock prices and by increasing financial market volatility and excess bond premia.

Summing up, noise seems to be an empirically and economically relevant component of monetary policy. Further, our results suggest caution in the use of forward-looking language in the conduct of monetary policy in the sense that providing information about the future path of the policy rate can be valuable if
clearly communicated and credible.



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