Job Market Paper
Over the past two decades, central banks have been using verbal communication about their economic forecasts and future policy choices as a tool of monetary policy. There has been much study of the optimal interest rate policy for central banks, but not on the optimal communication policy. This paper answers a fundamental question: What is the optimal communication strategy about its prediction for the future state of the economy for central banks under full commitment? I address this question using the tools of Bayesian persuasion. I obtain three results. First of all, for a dovish central bank, which is willing to accept high inflation to lower unemployment, if a priori it is less likely to observe a signal for future economic weakness, the communication should be overly pessimistic about its prediction for the future state of the economy. Second, for a dovish central bank, if a priori it is more likely to observe a signal for future economic weakness, then the communication should be uninformative. Third, for a hawkish central bank, which is not willing to accept much inflation irrespective of the unemployment level, the optimal communication strategy is uninformative. In preliminary empirical work using data from June 1999 to June 2006, I show that the Federal Open Market Committee’s forward guidance strategy deviates materially from these benchmark policy prescriptions.