Listening Without Understanding: Central Bank Transparency, Financial Markets and the Crowding Out of Private Information

The trend of monetary policy transparency has recently extended itself to the
practice of providing guidance on the likely direction of policy rates. There is a risk
that communicating the central bank’s own outlook for interest rates actually
undermines the financial markets’ ability to predict monetary policy. This paper
analyzes this risk using the Diamond (1985) model of a financial market, which
includes both costly private information acquisition and a costless public signal. We
demonstrate that a sufficiently precise signal from the central bank can result in a
deterioration of the financial market’s ability to predict monetary policy through the
crowding out of private information acquisition. Central banks could alleviate this
risk with a policy of limiting the guidance offered to the financial market in order to
leave sufficient scope for private information acquisition.