Central Banking: How Important are Words?

When central bankers speak, financial market participants, representatives of the media, and politicians listen with bated breath. Yet until very recently there has been very little systematic study of the role of verbal communication with the public by the central bank in monetary policy. CEP macro program member Carlo Rosa has been one of the first economists to shift attention from central bankers' deeds (the actual implementation of policy actions, such as a change in interest rates) to their words. Carlo's work confirms that modern monetary policy cannot be understood without looking at both dimensions.

It has already been long understood that when it comes to policy actions what matters most is the element of surprise: the difference between what the central bank does and what the markets had expected it to do. Carlo's work shows that something similar applies to central bank communication: what matters is the difference between what it says and what the market expected it to say.

Carlo's research addresses a number of questions. How can we objectively measure the tone of central bank statements? Do central bank qualitative announcements about the future path of the monetary policy affect market interest rates? How long does it take for these messages to be completely incorporated into asset prices? How does communication interact with learning by the public about the credibility of the central bank? What is more effective in moving asset prices in the USA and in Europe: central bank's words or deeds? In this respect, is the European Central Bank rhetoric more credible than the U.S. Federal Reserve communication?

To answer these questions Carlo created a set of methods to rank the central bank announcements into an ordered scale about the likelihood of future policy rate changes. It turns out that the unexpected component of central bank statements drives asset prices, especially long-term interest rates, even more than actually policy actions. The reaction of the American yield curve to Fed's statements is significantly larger than the response of European interest rates to ECB's announcements, and this finding is intimately related to the higher transparency of U.S. Fed statements compared to ECB announcements, rather than to the different institutional mandate of the two central banks.

The value added of this research is two-fold. On the one hand, it contributes to the rapidly expanding literature on central bank communication by shedding further light on asset price reactions to monetary policy actions and announcements. On the other hand, it contributes to the empirical finance literature by analyzing the effects of a new type of news item, specifically the information originating from central bank announcements, rather than announcements about macroeconomic fundamentals. The effects documented have relevant implications not only for a better understanding of the monetary policy transmission mechanism, but also for yield curve modeling and for microstructure of bond markets.

To read more about work on central bank communication see:

• "Central Bank's Two-Way Communication with the Public and Inflation Dynamics" [Full document in Adobe PDF] (Kosuke Aoki and Takeshi Kimura), CEP Discussion Paper 0899, November 2008
  
  
• "The Impact of Central Bank Announcements on Asset Prices in Real Time: Testing the Efficiency of the Euribor Futures Market" [Full document in Adobe PDF] (Carlo Rosa and Giovanni Verga), CEP Discussion Paper 0764, December 2006
  
  
• "The Importance of the Wording of the ECB " [Full document in Adobe PDF] (Carlo Rosa and Giovanni Verga), CEP Discussion Paper 0694, June 2005
  
  
• "Is ECB Communication Effective?" [Full document in Adobe PDF] (Carlo Rosa and Giovanni Verga), CEP Discussion Paper 0682, April 2005