Prior to the 1990s, central banks were shrouded in mystery – and believed they should be. It was conventional wisdom among central bankers that monetary policymakers should say as little as possible and should say it cryptically. However, as it became increasingly clear that managing expectations is a useful part of monetary policy, communication policy rose in stature from a nuisance to a key instrument in the central banker’s toolkit (see Blinder et al., 2008). Greater disclosure and clarity over policy may lead to greater predictability of central bank actions, which, in turn, reduces uncertainty in financial markets. Today, many central bankers strongly believe that a high degree of predictability is important.
Like many other central banks, the European Central Bank (ECB) has actively used communication policies since it opened its doors in 1998. There is substantive evidence that ECB communications move financial markets in the intended direction (see, for instance, Ehrmann and Fratzscher, 2007). There is also a consensus that ECB communications increase the predictability of interest decisions by the ECB (De Haan, 2008). However, there is less agreement as to whether communication adds information compared to the information contained by macroeconomic variables that are typically included in a model based on the Taylor rule. Does it pay to listen to the ECB President even if the latest information on the state of the economy is taken into account?
Taylor (1993) suggested that a simple monetary policy rule relating the nominal short-term interest rate to inflation and the output gap accurately describes US monetary policy over the period 1987-1992. The Taylor rule seems a reasonable description of central bank behaviour in other countries as well. However, as Svensson (2003) has shown, even if the ultimate objective of monetary policy is to stabilise inflation and output, a simple Taylor rule will not be optimal in a reasonable macroeconomic model. Interest rate changes affect inflation and output with a sizable lag. Therefore, monetary policy has to be forward-looking, i.e., it should be based on expected inflation and output.
In a recent paper (Sturm and De Haan, 2009), we examine to what extent ECB communication adds information about forthcoming interest rate decisions compared to the information provided by a Taylor rule model featuring expected inflation and output. Our dependent variable is the Main Refinancing Rate as determined by the ECB Governing Council. Real-time expected inflation and output growth time series have been constructed from Consensus Economics forecasts. These forecasts are used as a proxy for expectations of inflation and output growth.
We employ various indicators of ECB communication that are all based on the ECB President’s introductory statement at the press conference following an ECB policy meeting. These indicators try to quantify ECB communications in order to determine to what extent communication has its intended effects. Communications must be classified according to their content and/or likely intention, and then coded on a numerical scale. Negative (positive) values are assigned to communications that are perceived as dovish (hawkish), and zero to those that appear to be neutral. The most important weakness of this approach is that it is necessarily subjective, and there may be misclassifications. Indeed, even though the indicators that we use are all based on the same information set they differ quite substantially from one another. Despite these differences, we find that the indicators turn out to be very significant in our Taylor rule model. Also, if the interbank rate is included, the ECB communication indicators remain significant.
In other words, it is worthwhile for financial market participants to read the ECB President’s lips, as this adds information about upcoming interest rate decisions that is not provided by expected inflation and expected output growth.
Blinder, A.S., Ehrmann, M., Fratzscher, M., De Haan, J., Jansen, D. (2008). Central bank communication and monetary policy: A survey of theory and evidence. Journal of Economic Literature, 46(4), 910–45.
De Haan, J. (2008). The effect of ECB communication on interest rates: An assessment. The Review of International Organizations, 3(4), 375-398.
Ehrmann, M., Fratzscher, M. (2007). Communication by central bank committee members: Different strategies, same effectiveness? Journal of Money, Credit, and Banking, 39 (2-3), 509-541.
Sturm, J-E., De Haan, J. (2009), Is central bank communication really informative when forecasting interest rate decisions? New evidence based on a Taylor rule model for the ECB. CESifo working paper, forthcoming.
Svensson, L.E.O. (2003). What Is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules. Journal of Economic Literature, 41, 427-477.
Taylor, J.B. (1993). Discretion versus Policy Rules in Practice. Carnegie-Rochester Conference Series on Public Policy, 39, 195-214.