28-29 April 2009

Is central bank communication really informative when forecasting interest rate decisions? New evidence based on a Taylor rule model for the ECB

Jakob de Haan (University of Groningen) and Jan-Egbert Sturm (KOF, ETH Zurich)

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Outline

Introduction Theoretical framework Data Empirical results Summary

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The role of communication in monetary policy

Communication strengthens the effectiveness of monetary policy

– If credible it can influence expectations by creating a strong belief that inflation will return to its target

fosters more openness

– Central bank independence requires accountability –accountability requires disclosure

may lead to more (financial) market stability

– Predictability reduces market uncertainty

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How successfull was ECB communication?

ECB communication moves financial markets in the right direction (Ehrmann/Fratzscher 2007, Musard-Gies 2006, Brand et al. 2006)

ECB communication affects the euro-dollar exchange rate(Conrad/Lamla 2007, Fratzscher 2004, Jansen/De Haan 2005, 2007a, Siklos/Bohl 2006)

ECB communication helps explain interest rate decisions(De Haan 2008)

But, does it really add new information? Heinemann/Ulrich 2007, Rosa/Verga 2007: yes Jansen/De Haan 2006: questionable

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Problems in the literature on central bank communication and interest rate decisions Most policy rules are estimated using (backward-looking)

output gap and inflation measures However, central banks are forward-looking and do not have access to the ex-post data researcher have

– Analysis should be based on real-time data(Gorter et al. 2008, Sauer/Sturm 2003, 2007, Sturm/Wollmershäuser 2008)

Policy rules contain limited information: inflation and output gap measures There is additional information available

– Most of this should be reflected in the actual money market rate The usual frequency employed is monthly,

ignoring the timeline of events within a month

– When is what kind of information available?

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Taylor rule (Taylor, 1993)

Policy instrument of a Central Bank: nominal short-term interest rate (it)

A Central Bank should react to: deviations of inflation (t) from target (*)

deviations of output (yt) from potential (y*)

• it = (r*+*) + (t–*) + (yt–y*)

where r* is the neutral real interest rate, and >0, >1 “Taylor principle”: >1

– if inflation increases, then – in order to raise the real rate –the nominal interest rate must increase more (i>)(Otherwise self-fulfilling bursts of inflation may be possible)

Theoretical justification: e.g. Svensson (1999) Such a rule is optimal for a Central Bank pursuing an inflation target

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Modified Taylor (or speed limit, or difference) rule

How to measure the output gap, (yt–y*)?

We assume a constant potential growth rate and include (yt–y*)

• it = (r*+*) + (t–*) + (yt-y*)

Motivations ECB does not focus on the output gap (Gerlach, 2007) Measurement issues w.r.t. the output gap

– Walsh (2003) and Geberding et al. (2004) argue that such a rule performs well in the presence of imperfect information

Growth rate cycles in general have a clear lead over classical cycles Most theoretical models abstract from long-run growth

– When allowing for trend growth, the optimal policy rule can be specified in terms of output growth

Forecasts are normally formulated in terms of growth rates

– (Expected) growth rates are readily available

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Modified Taylor rule (continued)

it = (r*+*) + (t–*) + (yt–y*t )

Traditionally actual (ex-post) inflation rate and output gap are used Backward-looking Taylor rules

Monetary policy operates with a lag and tries to affect future inflation Sauer and Sturm (2003, 2007) argue that Taylor Rules should be

forward-looking (and use real-time data) Gorter et al. (2008) confirm this using Consensus forecasts

it = (r*+*) + (Ett+12 –*) + (Etyt+12–y*)

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Interest rate smoothing

Central banks tend to move policy rates in small steps We view the previous equation to determine target interest rate, iTt

iTt = (y*+*) + (Ett+12 –*) + (Etyt+12–y*)

Actual interest rate, it, adjusts only slowly to this target

it = it-1 + (1 – )iTt + vt or: it = (1 – )(iTt – it-1) + vt

Observed inertia may also be explained by serially correlated error terms in the policy rule (omitted shocks like financial crises) (Rudebusch, 2002) vt = vt-1 + t

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Data

Coverage: Euro area, 1999–2007 However: most communication indicators only available for 1999–2004

Dependent variable: Main refinancing rate (MRR)

(as determined on ECB Governing Council meetings) Explanatory variables:

Expected inflation and expected GDP growth

– both taken from Consensus Economics Inc.and published before each ECB meeting

Communication indicators based upon ECB press releases Robustness check:

– Difference between MRR and the 1-month interbank rate (IBR)

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The policy/interbank rate and growth/inflation expect.

Sources: ECB, Datastream, Consensus Economics

Inflation

Growth

IBRMRR

0

1

2

3

4

5

0

1

2

3

4

5

1999 2000 2001 2002 2003 2004 2005 2006 2007

% %

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Communication variables

Means of communication Introductory statements after the monthly GC meetings Monthly Bulletins Irregular speeches and interviews

Data sources News tickers: Jansen/De Haan (2005), Ehrmann/Fratzscher (2007) Monthly Bulletin: Gerlach (2007) Press release after the Governing Council meeting

– Heinemann and Ullrich (2007) Covering 1999-2004(H&U)

– Berger, De Haan and Sturm (2006) Covering 1999-2004(BHS)

– Rosa and Verga (2007) Update Covering 1999-2007(R&V)

– KOF Monetary Policy Communicator Covering 1999-2007(MPC)

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Some background information on the KOF MPC

General problems of central bank communication indicators either too difficult to automate (subjectivity)

or too simple to be informative (simple word count) Solution: Media content analysis Media Tenor codes each introductory statement on the statement level The KOF MPC takes the balance of statements

that reveal upside risks and those that reveal downside risks to future price stability, relative to all such statements By construction, the index is restricted to [-1,1]

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The raw communication data (1)

Sources: Heinemann and Ullrich (2007), Berger et al. (2006)

-2

-1

0

1

2

3

4

1999 2000 2001 2002 2003 2004

-2

-1

0

1

2

3

4H&U, BHS H&U, BHS

BHS

H&U

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KOF MPC

The raw communication data (2)

Sources: Rosa and Verga (2007), KOF

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

1999 2000 2001 2002 2003 2004 2005 2006 2007

-1.25

-1.00

-0.75

-0.50

-0.25

0.00

0.25

0.50

0.75

1.00

1.25R&V KOF MPC

R&V

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Timeline

Council meeting interest rate decision press communiqué

Councilmeeting

Release consensus inflation exp. growth exp.

New interest rate decision

time

Approximately one month

Interbank rate

At what moment in time do we forecast? At release date of Consensus Forecasts

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Correlation table of explanatory variables

(1) (2) (3) (4) (5) (6) (7) (8)

(1) MRR

(2) IBRt=CF - MRR

(3) Inflation exp.

-0.02 0.43 0.62

-0.20 0.31

-0.01(4) Growth exp.

0.21 0.27 0.32 0.04

0.35 0.29 0.40 0.13

0.26 0.14 0.15 0.170.51 0.71 0.77 0.16

(5) R&V(6) H&U (7) BHS

0.78 0.87 0.520.81 0.33

0.28(8) KOF MPC

-0.07

0.52 -0.250.55 0.35 -0.03

0.25 0.36 0.07 0.730.28 0.28 0.16 0.72 0.780.29 0.40 0.15 0.76 0.87 0.81-0.08 0.06 0.04 0.19 0.42 0.34 0.29

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Baseline models

(1) (2)

MRR t-1 ρ

Inflation exp. t=CF β

Growth exp. t=CF γ

Constant r*

-0.105 ***

(-3.480)

0.165 *

(1.670)

0.191 ***

(4.092)-0.389 **

(-2.187)

0.895 ***

(29.780)

1.581 **

(2.084)

1.823 ***

(6.309)1.086 ***

(6.316)

ObservationsR-squaredLog likelihood

Implied structural parametersOLS

0.22351.59

101

(3)

MRR t-1 -1.006 ***

(-3.928)

Inflation exp. t=CF 1.772 **

(2.274)

Growth exp. t=CF 1.762 ***

(4.712)

-56.65

Ordered Probit

101

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Models from t=CF perspective, Ord.Probit (1)

MRRt-1

Inflation exp.t=CF

Growth exp.t=CF

-0.855 ***

(-2.888)-0.056

(-0.062)0.873 *

(1.777)

-0.969 ***

(-2.631)0.136

(0.110)1.600 **

(2.454)

-0.997 **

(-2.417)-0.582

(-0.544)0.572

(0.989)

-0.964 ***

(-3.717)1.522 **

(2.071)1.702 ***

(4.261)

Comm.ind.t-1 1.131 ***

(3.921)

0.462 *

(1.795)

1.619 ***

(3.215)

0.887

(1.296)Comm.ind.t-2

Observations

Log likelihood

BHS

(3)

MPC

(4)

R&V

(1)

H&U

(2)

98

-41.74

67

-30.93

68

-23.68

101

-55.82

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Models from t=CF perspective, Ord.Probit (2)

MRRt-1 -0.805 *** -0.933 ** -0.952 ** -0.885 ***

(-2.580) (-2.363) (-2.356) (-3.350)Inflation exp.t=CF 0.310 -0.363 -0.531 1.129

(0.318) (-0.246) (-0.488) (1.365)Growth exp.t=CF 0.883 1.230 0.612 1.539 ***

(1.636) (1.709) (1.058) (3.856)

Comm.ind.t-1

Comm.ind.t-2

1.111 *** 0.470 * 1.722 *** 0.741

(3.083) (1.748) (2.869) (1.092)0.003 0.328 -0.207 1.856 ***

(0.009) (1.263) (-0.476) (2.920)

Observations

Log likelihood

R&V H&U BHS MPC

(6) (7) (8) (9)

94

-38.97

65

-30.05

67

-23.58

100

-52.64

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Models from t=CF perspective, Ord.Probit (incl. IBR)

MRRt-1 -0.799 ** -0.816 ** -1.111 ** -0.883 *** -0.770 ** -0.802 ** -1.090 ** -0.829 ***

(-2.325) (-2.220) (-2.184) (-3.217) (-2.193) (-2.066) (-2.332) (-2.933)IBRt=CF - MRRt-1 4.594 ** 7.27 *** 7.425 *** 5.541 *** 4.355 ** 7.336 *** 7.389 *** 5.141 ***

(2.210) (2.578) (2.756) (2.892) (1.972) (2.629) (2.735) (2.710)Inflation exp. t=CF 0.435 0.597 0.461 2.047 *** 0.846 0.613 0.474 1.664 **

(0.466) (0.465) (0.417) (2.659) (0.862) (0.425) (0.426) (2.005)Growth exp. t=CF 0.563 1.000 0.335 1.334 *** 0.691 0.979 0.340 1.225 ***

(1.100) (1.499) (0.561) (3.332) (1.286) (1.206) (0.563) (3.049)

Comm.ind. t-1 1.082 *** 0.635 * 1.782 *** 0.704

(3.937) (1.709) (3.401) (0.967)Comm.ind. t-2

1.047 *** 0.638 * 1.809 *** 0.609

(2.997) (1.685) (2.903) (0.863)

0.006 -0.032 -0.063 1.527 **

(0.021) (-0.115) (-0.121) (2.501)

Observations

Log likelihood

R&V H&U BHS MPC R&V H&U BHS MPC

(1) (2) (3) (4) (6) (7) (8) (9)

98 67 68 101 94 65 67 100

-37.15 -23.52 -18.12 -48.21 -35.20 -23.44 -18.11 -46.40

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Summary

Central bank communication has become an important tool in monetary policy

We estimate state-of-the-art Taylor rules Forward-looking (and real-time) data Good and robust fit describing actual ECB monetary policy well

Communication indicators focusing on the introductory statement released at the monthly press release of the ECB in general contain information on upcoming interest rate decisions Even when correcting for market expectations

contained in the 1-month interbank money market rate The KOF Monetary Policy indicator appears to have a longer lead

than other communication indicators