Kites & Quails: Monetary Policy and Communication with Strategic Financial Markets

Abstract

We propose a simple model to study the consequences of including financial market stability among the central bank’s objectives when market players are strategic and their stability is compromised by policy surprises. In this set-up, the central bank underreacts to economic shocks, a prediction that we show is consistent with the behavior of the Federal Reserve during the 2023 banking crisis. Moreover, the inclusion of stability among the policy objectives biases investors’ choices, inducing inefficiency. If the central bank has private information about its policy intentions, the equilibrium forward guidance is vague, because fully informative communication is not credible. A “kitish” central banker, who puts little weight on market stability, reduces these inefficiencies. Repeated interactions can replicate the first best but also sustain welfare-detrimental collusive equilibria.