The tone of a central bank’s communication matters for asset prices, according to a new European Central Bank study demonstrating the impact of words used to describe the context for monetary policy. The ECB has developed a specific indicator to measure the tone of its policy messages compared to the Federal Reserve.
In a blog post on the ECB website, Frankfurt-based researchers said they discovered evidence showing that differences in policy tones between the ECB and the Federal Reserve led to changes in the euro-dollar exchange rate and that speeches by policymakers in-between official policy meetings also can affect financial markets.
“What central banks say can influence prices on financial markets and, ultimately, how the economy evolves,” said the ECB’s researchers. “That makes communication an important tool of monetary policy as it helps clarify policymakers’ reaction function and steer expectations.”
Policy tone affects exchange rates, markets
The ECB team, composed of Jean-François Bouscasse, Daniel Kapp, Thomas McGregor and Julian Schumacher, said it found that differences in policy tone between the ECB and Fed also help to explain changes in the euro-dollar exchange rate. In addition to the communication following policy meetings, communications in-between such meetings, such as with speeches by policymakers, can also affect financial markets.
ECB research therefore found it useful to measure and quantify the sentiment or tone of what central banks communicate over time. They did so by analysing how “hawkish” or “dovish” their policy statements and press conferences are, referring to the terms economists use to describe the extent to which communication indicates whether monetary policy is expected to tighten - hawkish - or loosen - dovish.
The overall tone of the Fed’s and ECB official meeting communication turned increasingly hawkish around early 2021 and mid-2021, respectively. This was about a year before the two central banks started to actually raise rates. Another finding pointed to a different policy tone between the ECB and Fed based on both meeting and inter-meeting communications.
Hawkish Fed, lower euro
In early 2021, the Fed started to communicate in more hawkish terms relative to the ECB, according to the ECB’s tone indicators. At the same time the euro began to depreciate against the US dollar – to a greater extent than what would have been suggested by the widening in short-term interest rate differentials.
This trend reversed to some extent as the policy tones of the two central banks grew closer again towards the end of 2022. “Overall, this observation is consistent with central bank communication playing a significant role in guiding interest rate expectations and, by extension, exchange rate developments,” ECB researchers said in their blog post.
ECB (lhs) and Federal Reserve (rhs) topic-tone indicators