Monetary Policy and Communication with Strategic Financial Markets

Abstract

We propose a model to study the consequences of including financial stability among the central bank’s objectives when market players are strategic, and surprises compromise their stability. In this setup, central banks underreact to economic shocks, a prediction consistent with the Federal Reserve’s behavior during the 2023 banking crisis. Moreover, policymakers’ stability concerns bias investors’ choices, inducing inefficiency. If the central bank has private information about its policy intentions, the equilibrium forward guidance entails an information loss, highlighting a trade-off between stabilizing markets through policy and communication. A “kitish” central banker, who puts less weight on stability, reduces these inefficiencies.