Abstract
Monetary policy and financial markets are intrinsically linked. Central banks conduct monetary policy by influencing financial market prices. Financial market prices reflect expectations of market participants about future economic and monetary developments. Monetary policy works primarily through expectations. Transparency and credibility render monetary policy more effective. However, they are no substitute for action. If a credible central bank uses words with explicit aim of substituting them for action, it will risk losing credibility. To avoid what has been described as the dog chasing its tail problem, central banks must exercise caution in basing their monetary policy decisions on financial market information. The information about expected future developments reflected in market prices must be continuously cross-checked against economic and monetary indicators in what amounts to a checks and balances approach to monetary policy.
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