TAILIEUCHUNG - The Expected Interest Rate Path: Alignment of Expectations vs. Creative Opacity∗

In addition to redefi ning the calculation of capital requirements and establish- ing a supervisory review process under Pillars 1 and 2, Basel II imposes new and enhanced disclosure obligations on credit institutions under its third pillar. The purpose of Pillar 3 is to ensure greater transparency in terms of banks’ activities and risk strategies, as well as to enhance comparability across credit institutions – which is all in the interests of market participants. At the same time, the provisions of Pillar 3 do not entail additional capital requirements but are limited to mandating the publication of key data, the. | The Expected Interest Rate Path Alignment of Expectations vs. Creative Opacity Pierre Gosselin a Aileen Lotz b and Charles Wyploszb aInstitute Fourier University of Grenoble bThe Graduate Institute Geneva We examine the effects of the release by a central bank of its expected future interest rate in a simple two-period model with heterogeneous information between the central bank and the private sector. The model is designed to rule out common-knowledge and time-inconsistency effects. Transparency when the central bank publishes its interest rate path fully aligns central bank and private-sector expectations about the future inflation rate. The private sector fully trusts the central bank to eliminate future inflation and sets the long-term interest rate accordingly leaving only the unavoidable central bank forecast error as a source of inflation volatility. Under opacity when the central bank does not publish its interest rate forecast current-period inflation differs from its target not just because of the unavoidable central bank expectation error but also because central bank and privatesector expectations about future inflation and interest rates are no longer aligned. Opacity may be creative and raise welfare if the private sector s interpretation of the current interest rate leads it to form a view of expected inflation and to set the long-term rate in a way that systematically offsets the effect of the central bank forecast error on inflation volatility. Conditions that favor the case for transparency are a high degree of precision of central bank information relative to private-sector information a high precision of early information and a high elasticity of current to expected inflation. JEL Codes D78 D82 E52 E58. We acknowledge with thanks helpful comments from an anonymous referee Alex Cukierman Martin Ellison Hans Genberg Petra Geraats Charles Goodhart Craig Hakkio Glenn Rudebusch Laura Veldkamp Anders Vredin 145 146 International Journal of Central .

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