decision framework used by the monetary authority and / or its assessment of current and prospective economic, monetary and financial developments. i would argue that some ‘ teething problems ’ in communication with financial markets are inevitable for a new institution. the ecb is still learning about how best to communicate its message to the markets. the financial markets are still learning – from our track record – about the application of the ecb ’ s monetary policy strategy. i will now turn my attention to the evidence on the extent to which ecb monetary policy has been both credible and predictable in the eyes of the financial markets. a key indicator of credibility of ecb monetary policy comes from expectations of inflation implied by the differences between the returns on real and nominal bonds. in this regard, the break - even inflation rate french index linked bonds has been consistently been in line with the ecb ’ s quantitative definition of price stability, indicating a persistently high degree of credibility for ecb monetary policy. moving to the question of predictability it seems fair to say that policy moves have generally been anticipated by the money markets. this can be seen if one looks at the implied short term interest rates and the subsequent official interest rate moves which seem to exhibit a high degree correspondence. according to work undertaken by gaspar, perez - quiros & sicilia ( 2001 ) who examine the behaviour of overnight interest rates, the markets do not appear to make systematic errors with respect to monetary policy announcements. furthermore, developments in the volatility implied by options on 3 - month euribor futures indicate that the degree of uncertainty among investors with respect to future developments in short - term interest rates generally declines following an interest rate change by the ecb. indeed, the extent of this uncertainty around the time of interest rate changes seems to have diminished in magnitude over time. this is consistent with the notion that investors have become more confident in their forecasts of future short - term interest rate developments prior to ecb monetary policy announcements. nevertheless, one could not claim that on every single occasion policy has always been well anticipated by the money markets. this can be seen in the fact that on two occasions this year – on the 21st and 22nd of february and the 12th and 17th of april – there was underbidding in the eurosystem ’ s main refinancing operations. it appears that most market participants were expecting a reduction in interest rates and therefore preferred not to participate in the auctions. when these expectations were not fulfilled there was a shortage of

in a manner consistent with the monetary policy strategy, thus aiding the smooth conduct of monetary policy. for example, where the markets correctly anticipate that a new piece of information will lead to a change in official interest rates they will do ‘ much of the work ’ themselves through a change in the term structure. in such an environment, communication by the monetary authority is of the utmost importance and is directed towards informing the markets of its assessment of the outlook for price stability and preparing the markets for future policy moves, thereby avoiding unnecessary volatility and supporting the smooth conduct of policy. another idea is that the financial markets lead and the monetary authority follows. in such a world, the monetary authority will seek to satisfy the expectations of financial markets – in the extreme case : whatever they are – by never surprising them. if the monetary authority does not do what is expected the financial markets will ‘ punish ’ it – for example by demanding higher risk premia to cover the greater uncertainty. an important point to bear in mind here is that it can sometimes appear that the financial markets are leading the monetary authority when in fact the reverse is true. this is because the ‘ rule like ’ behaviour i mentioned earlier will lead the markets to correctly anticipate monetary policy decisions and hence to react in advance of the monetary authorities. nevertheless, it is still the monetary policy strategy of the monetary authority that determines the reaction. as i have already indicated i do not support the idea that the monetary authority should ‘ follow the markets ’. to explain why i will rely on a quote from allan blinder, who puts the argument very succinctly : “... following the markets may be a nice way to avoid unsettling financial surprises, which is a legitimate end in itself. but i fear it may produce rather poor monetary policy, for several reasons. one is that speculative markets tend to run in herds and to overreact to almost everything. central bankers need to be more cautious and prudent. another is that financial markets seem extremely susceptible to fads and speculative bubbles, which sometimes stray far from fundamentals. central bankers must inoculate themselves against whimsy and keep their eyes on the fundamentals. finally, traders in financial markets – even those for long - term instruments – often behave as if they have ludicrously short time horizons, whereas maintaining a long time horizon is the essence of proper central banking. ” obviously there are few people who would argue that it makes sense for monetary