Essays on Monetary Policy in Israel
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The current consensus is that central bank communication in the form of forward guidance has a profound effect on monetary policy effectiveness. Forward guidance affects private sector expectations about the future path of the short-term interest rate, which in turn affects interest rates with longer maturities, thus shaping economic decisions of households and companies. There is no consensus, however, on the degree of forward guidance a central bank should exercise. My dissertation, titled “Essays on Monetary Policy in Israel”, and comprised of two essays, explores this question by using Israel as the case study. In one of its recent annual publications, the Bank of Israel evaluates its past policy decisions using a Taylor-type policy rule. A policy rule can be thought of as an ultimate forward guidance instrument, because it provides both an explicit policy objective and a clear strategy for achieving that objective. In the first chapter of my dissertation titled “Policy Rules in Practice: The Case of Israel”, I study whether this level of openness helps policymakers conduct monetary policy consistent with their long term objectives. I use this published policy rule to find that, with the exception of the 2008 financial crisis, monetary policy in Israel can be systematically described as rules-based in the past fifteen years. Immediately after the 2008 crisis, however, the policymakers have exercised flexibility in terms of their primary goal, price stability, as there was more focus on stabilizing economic activity as opposed to inflation. I then assess how market expectations about the future path of the short-term interest rate respond to both the increase in policy transparency and the exercised flexibility during the financial crisis. To examine the increase in policy transparency, I use futures contracts on short term interest rates from the inter-bank market, and find that monetary policy predictability improves in the period following the publication of this rule. This result reveals the value of a simple policy rule as a tool of communication, enabling policymakers to anchor market expectations even in times of greater economic uncertainty. The second chapter of my dissertation, “Text Mining and Central Bank Communication”, extends the question of how much central banks should reveal, by assessing qualitative information in the form of interest rate statements, published by the Bank of Israel. Using modern text mining techniques, I extract the informational content from the set of monthly interest rate decision statements, published from 2006 to 2016. I con- struct a dictionary based sentiment measure, and estimate it in a Taylor type forward looking reaction function. I examine whether the sentiment measure can provide a clear signal about the future direction of monetary policy, and find that, in combination with standard macroeconomic variables, i.e. output gap and inflation, the sentiment measure improves short-run predictability of policy rate decisions. Overall, I find evidence that increased communication has a positive effect on monetary policy effectiveness, with financial markets able to correctly anticipate monetary policy decisions in Israel.