How ECB’s word choice influences financial market

FRANKFURT. Eight times a year, the European Central Bank (ECB) sets the key interest rate and announces it through press releases and press conferences. A study by Professor Christian Wagner (Vienna University of Economics and Business) and Professor Maik Schmeling (Goethe University Frankfurt) shows that not only the key interest rate but also the way the ECB communicates it has an impact on financial markets.

The ECB’s most important job is to ensure price stability in the euro area, avoiding major fluctuations in the value of money and maintaining an inflation rate of around 2%. One important instrument for this is the key interest rate, which forms the basis both for financial market transactions and for the conditions applied to savings and loans. If the ECB lowers the key interest rate, saving money become less attractive, while loans become more affordable. Approximately every six weeks, the ECB sets the current key interest rate and publishes its decision at 1:45 pm in a short announcement. At 2:15 pm this is followed by a press conference in which the central bank explains the rationale behind its interest rate decision and gives its assessment of further economic developments.

In a current research project, Christian Wagner (Vienna University of Economics and Business) and Maik Schmeling from Goethe University investigated whether the way in which the ECB communicates it monetary policies is also reflected in asset prices such as stocks. The result: a change in the ECB’s tone has a significant effect on the prices of financial instruments. If the ECB’s word choice is more positive, then stock prices rise, while derivatives used to hedge risks become cheaper. “A positive word choice seems to increase market participants’ willingness to take risks, leading to rising stock prices,” says Maik Schmeling from Goethe University. The authors were also able to show that a more optimistic tone on the part of the ECB is an indicator of more favourable economic developments. Future interest rate changes can be predicted based on the tone of the ECB’s communications. In other words, the way in which the ECB communicates with the market allows conclusions to be drawn about its future interest rate policy.

The results of this study are particularly relevant with regard to central banks’ capacity to act, because they show that through their choice of words, central banks can influence market participants’ expectations and willingness to take risks. The communication strategy of a central bank therefore represents an instrument of money policy on its own. For market participants, the results of the study mean that listening closely to the tone of the ECB will provide additional clues for making investment and financing decisions. The authors of the study analysed the ECB’s tone and generated a time series of changes in tone from one press conference to the next. This makes it possible to observe how stock prices and other financial instruments changed depending on the ECB’s tone. For their analysis, Wagner and Schmeling used high-frequency financial data, which is available at one-minute intervals, allowing them to track price developments right from the start of the press conference. In their analysis, the researchers also controlled for the level of interest rate changes and other “hard facts” published during the press conference, such as growth and inflation forecasts.

Maik Schmeling has been professor for finance at the Faculty of Business and Economics at Goethe University since May 2018. From 2013 to 2018, he was professor of finance at the Cass Business School, City, University of London. In his research, Maik Schmeling focuses on various issues in the field of international financial markets, such as risk premiums on currency and money markets, the connection between monetary policies and asset prices, and the formation of expectations on financial markets. Schmeling has published in such internationally renowned publications as the “Journal of Finance,” the “Journal of Financial Economics” and the “Review of Financial Studies.”

Publication: Schmeling, Maik and Wagner, Christian, Does Central Bank Tone Move Asset Prices? (October 23, 2019). Available at: https://ssrn.com/abstract=2629978 or http://dx.doi.org/10.2139/ssrn.2629978

/Public Release. View in full here.