Expectations and the Central Banker: Making Decisions the Market Expects to See?

Abstract

This paper develops a simple model to examine conditions under which a monetary policy-making authority is tempted to ‘follow the market’. In doing so, we explore the implications of increased market consensus on the practice of monetary policy and show that inefficiency in policymaking is most likely precisely when there is a very high consensus that economic fundamentals are weak or strong. In addition, our results also shed light on (i) why interest rates may not be high enough even when the central bank's information suggests a rise in asset prices may be due to a ‘bubble’ shock; (ii) why a central banker may be reluctant to adopt a loose monetary policy even when investors seem to be very pessimistic about the path of future output; and (iii) why, contrary to conventional models, we sometimes observe an upward revision of private sector‘s forecasts of inflation when the central bank tightens its monetary policy. The results have implications for the transparency of monetary policy.