The other side of forward guidance: Are central banks constrained by financial markets?

We present a theoretical model in which the central bank cares about the short-term stability of financial markets, which gives it an incentive to keep market expectations about future rates at a low level. This incentive is stronger when financial institutions are perceived to be fragile, because the impact on financial stability of a rise in rate expectations is higher in that context. Empirically, both the long-term target of the central bank and the short-term health of the financial sector are strong predictors of the evolution of US Treasury notes rates between two central bank meetings.