Why Do Financial Market Experts Misperceive Future Monetary Policy Decisions?

Central bank communication is increasingly important to both central banks and financial market participants. Effective communication should ensure that financial markets understand the central bank's interest rate policy. However, central bank communication is not always effective and interest rate forecast errors can occur for two reasons. First, forecasters may understand monetary policy but misperceive future interest rate decisions simply because they are wrong about future in°ation and output. Second, the forecasters may fail to understand monetary policy and the interest rate rule applied by the central bank. This paper aims to shed more light on communication by the European Central Bankm (ECB), disagreement among ¯nancial experts over future interest rate decisions, and the sources of policy misperception. To this end, we use survey data on expected interest rates, inflation and output growth from the Financial Market Survey collected by the Centre for European Economic Research. We assume that the ECB sets the interest rates according to a Taylor rule and that the surveyed financial market experts base their interest rate forecasts on a Taylor rule likewise. In the following, we form interest rate forecast errors and decompose them according to a Taylor{rule{type model. Consequently, we can infer whether the financial market experts correctly perceive the ECB reaction function. The empirical findings show that the ¯nancial market experts systematically misperceive the ECB's Taylor rule parameters. More precisely, their estimate of the inflation parameter is higher than the ECB's inflation parameter but becomes more accurate after an ECB clarification about its monetary policy strategy in May 2003. The estimation results further suggest that the disagreement among experts about the ECB's reaction to inflation has not increased since the financial market crisis.

Schmidt, Sandra and Dieter Nautz (2010), Why Do Financial Market Experts Misperceive Future Monetary Policy Decisions?, ZEW Discussion Paper No. 10-045, Mannheim.