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Monetary Policy Announcements of the Reserve Bank of India and the Role of Information Shock
Inflation-targeting central banks supplement their monetary policy announcements with communication in the form of speeches and publication of text documents. The markets react to the surprise component of the rate action and the communication by the central bank. Thus, the monetary surprise derived from the reaction of markets, following a policy announcement, is agglutinated with the central bank information. The present paper attempts to identify and examine the efficacy of such an information shock in influencing the inflation expectations of households, interest rate expectations of agents, output and inflation.
The author gratefully acknowledges and thanks the anonymous referee for providing valuable comments. The usual disclaimers apply.
The success of monetary policy lies in not just effectively controlling the current overnight interest rates but also influencing market expectations regarding its future path (Woodford 2001). Expectations are important in financial markets, and also in achieving the final objectives of monetary policy. In financial markets, the market participants form their expectations about the policy rate based on the information available with them and accordingly deal in future contracts, thereby influencing long-term interest rates (Friedman 1980; Howe and Pigott 1991). Likewise, inflation-targeting central banks achieve the targeted inflation rate by anchoring the expected future inflation (Bernanke and Mishkin 1997; Svensson 1997). Managing expectations is thus a very crucial component of monetary policy and modern central banks have been using central bank communications as an important toolkit in this regard (Blinder et al 2008). By communicating the factors governing monetary policy strategy, the economic outlook of the country and that of future policy decisions, they attempt to anchor expectations (Blinder 2000). To elaborate further, the central banks supplement the monetary policy announcements regarding the policy rates, along with communication in the form of releasing the macroeconomic outlook of the country, future course of interest rates, etc, to achieve their final objectives (Bernanke 2015; Blinder 2000; Gürkaynak et al 2005; Woodford 2012). Thus, on the central bank policy announcement date, markets are subject to two types of shocks, namely pure monetary shock (attributable to the policy rate action of the central bank) and central bank information shock (attributable to the text documents and speeches delivered on the announcement date).
Measuring the efficacy of central bank communication, which takes place through text documents and speeches—as against the monetary policy announcements that make use of instruments like policy interest rates, cash reserve ratio (CRR), etc, which are cardinal numbers—is a daunting task. Likewise, using the policy instrument to derive monetary shocks may give rise to endogeneity in the regression models as the policy instrument may respond to economic conditions (Kuttner 2001; Lakdawala and Sengupta 2021). The pioneering contribution of Kuttner (2001) in deriving monetary surprises using high-frequency indicators (HFIs) circumvents this problem.1,2 However, the monetary surprise so derived would be agglutinated with the central bank information as the bank also releases the macroeconomic outlook along with the monetary policy announcement.
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