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

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). Outline. Introduction Theoretical framework Data

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

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  1. 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)

  2. Outline • Introduction • Theoretical framework • Data • Empirical results • Summary Waterloo

  3. 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 Waterloo

  4. 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 Waterloo

  5. 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? Waterloo

  6. 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 Waterloo

  7. 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 Waterloo

  8. 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*+*) + (Ett+12 –*) + (Etyt+12–y*) Waterloo

  9. 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*+*) + (Ett+12 –*) + (Etyt+12–y*) • Actual interest rate, it, adjusts only slowly to this target • it = it-1 + (1 –)iTt + vtor: 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 Waterloo

  10. 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) Waterloo

  11. IBR MRR Growth Inflation Sources: ECB, Datastream, Consensus Economics The policy/interbank rate and growth/inflation expect. % % 5 5 4 4 3 3 2 2 1 1 0 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 Waterloo

  12. 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) Waterloo

  13. 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] Waterloo

  14. H&U Sources: Heinemann and Ullrich (2007), Berger et al. (2006) The raw communication data (1) H&U, BHS H&U, BHS 4 4 3 3 2 2 BHS 1 1 0 0 -1 -1 -2 -2 1999 2000 2001 2002 2003 2004 Waterloo

  15. Sources: Rosa and Verga (2007), KOF The raw communication data (2) R&V KOF MPC 2.5 1.25 2.0 1.00 R&V 1.5 0.75 1.0 0.50 0.5 0.25 0.0 0.00 KOF MPC -0.5 -0.25 -1.0 -0.50 -1.5 -0.75 -2.0 -1.00 -2.5 -1.25 1999 2000 2001 2002 2003 2004 2005 2006 2007 Waterloo

  16. Release consensus inflation exp. growth exp. Councilmeeting Council meeting interest rate decision press communiqué Approximately one month At what moment in time do we forecast? • At release date of Consensus Forecasts Timeline New interest rate decision time Interbank rate Waterloo

  17. -0.02 0.43 0.62 0.21 0.27 0.32 0.04 -0.07 -0.20 0.31 0.35 0.29 0.40 0.13 0.52 -0.25 -0.01 0.26 0.14 0.15 0.17 0.55 0.35 -0.03 0.51 0.71 0.77 0.16 0.25 0.36 0.07 0.73 0.78 0.87 0.52 0.28 0.28 0.16 0.72 0.78 0.81 0.33 0.29 0.40 0.15 0.76 0.87 0.81 0.28 -0.08 0.06 0.04 0.19 0.42 0.34 0.29 Correlation table of explanatory variables (1) (2) (3) (4) (5) (6) (7) (8) (1) MRR IBR - MRR (2) t=CF (3) Inflation exp. (4) Growth exp. (5) R&V (6) H&U (7) BHS (8) KOF MPC Waterloo

  18. Ordered Probit (3) MRR -0.105 *** 0.895 *** -1.006 *** t-1 (-3.480) (29.780) (-3.928) Inflation exp. 0.165 * 1.581 ** 1.772 ** t=CF (1.670) (2.084) (2.274) Growth exp. 0.191 *** 1.823 *** 1.762 *** t=CF (4.092) (6.309) (4.712) -0.389 ** 1.086 *** (-2.187) (6.316) 101 101 0.223 51.59 -56.65 Baseline models Implied structural OLS parameters (1) (2) MRR ρ t-1 Inflation exp. β t=CF Growth exp. γ t=CF Constant r* Observations R-squared Log likelihood Waterloo

  19. -0.855 *** -0.969 *** -0.997 ** -0.964 *** (-2.888) (-2.631) (-2.417) (-3.717) -0.056 0.136 -0.582 1.522 ** (-0.062) (0.110) (-0.544) (2.071) 0.873 * 1.600 ** 0.572 1.702 *** (1.777) (2.454) (0.989) (4.261) 1.131 *** 0.462 * 1.619 *** 0.887 (3.921) (1.795) (3.215) (1.296) 98 67 68 101 -41.74 -30.93 -23.68 -55.82 Models from t=CF perspective, Ord.Probit (1) R&V H&U BHS MPC (1) (2) (3) (4) MRR t-1 Inflation exp. t=CF Growth exp. t=CF Comm.ind. t-1 Comm.ind. t-2 Observations Log likelihood Waterloo

  20. 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) Models from t=CF perspective, Ord.Probit (2) R&V H&U BHS MPC (6) (7) (8) (9) MRR -0.805 *** -0.933 ** -0.952 ** -0.885 *** t-1 (-2.580) (-2.363) (-2.356) (-3.350) Inflation exp. 0.310 -0.363 -0.531 1.129 t=CF (0.318) (-0.246) (-0.488) (1.365) Growth exp. 0.883 1.230 0.612 1.539 *** t=CF (1.636) (1.709) (1.058) (3.856) Comm.ind. t-1 Comm.ind. t-2 Observations 94 65 67 100 Log likelihood -38.97 -30.05 -23.58 -52.64 Waterloo

  21. 1.082 *** 0.635 * 1.782 *** 0.704 1.047 *** 0.638 * 1.809 *** 0.609 (3.937) (1.709) (3.401) (0.967) (2.997) (1.685) (2.903) (0.863) 0.006 -0.032 -0.063 1.527 ** (0.021) (-0.115) (-0.121) (2.501) Models from t=CF perspective, Ord.Probit (incl. IBR) R&V H&U BHS MPC R&V H&U BHS MPC (1) (2) (3) (4) (6) (7) (8) (9) MRR -0.799 ** -0.816 ** -1.111 ** -0.883 *** -0.770 ** -0.802 ** -1.090 ** -0.829 *** t-1 (-2.325) (-2.220) (-2.184) (-3.217) (-2.193) (-2.066) (-2.332) (-2.933) IBR - MRR 4.594 ** 7.27 *** 7.425 *** 5.541 *** 4.355 ** 7.336 *** 7.389 *** 5.141 *** t=CF t-1 (2.210) (2.578) (2.756) (2.892) (1.972) (2.629) (2.735) (2.710) Inflation exp. 0.435 0.597 0.461 2.047 *** 0.846 0.613 0.474 1.664 ** t=CF (0.466) (0.465) (0.417) (2.659) (0.862) (0.425) (0.426) (2.005) Growth exp. 0.563 1.000 0.335 1.334 *** 0.691 0.979 0.340 1.225 *** t=CF (1.100) (1.499) (0.561) (3.332) (1.286) (1.206) (0.563) (3.049) Comm.ind. t-1 Comm.ind. t-2 Observations 98 67 68 101 94 65 67 100 Log likelihood -37.15 -23.52 -18.12 -48.21 -35.20 -23.44 -18.11 -46.40 Waterloo

  22. 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 Waterloo

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