It’s not what you say, it’s how you say it: How wording used by the ECB affects financial markets

Eight times a year, the European Central Bank (ECB) sets key interest rates, which are announced in a press release and subsequent press conference. A study by WU Professor Christian Wagner and Maik Schmeling of Goethe University Frankfurt shows that not only the key rate itself 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, i.e. to avoid major fluctuations in the value of money and maintain 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. Christian Wagner, professor at WU’s Institute for Finance, Banking and Insurance, explains: “When the ECB lowers interest rates, saving money loses appeal, while loans become more affordable.” In a current research project, Wagner and Maik Schmeling investigated whether the way in which the ECB communicates its monetary policies is also reflected in the prices of financial instruments such as stocks.

A positive tone makes stock prices rise

The study shows that a change in the ECB’s tone has a significant effect on the prices of financial instruments. If the ECB’s choice of words is more positive, then stock indices rise, while the prices of derivatives used to hedge risk fall. “When the ECB communicates in a more positive tone, i.e. choosing words with a more positive connotation, market participants’ willingness to take risks increases,” explains Wagner. In addition, the authors of the study were able to show that a more optimistic tone on the part of the ECB is an indicator for more favorable economic developments. “We observed that future interest rate changes can be predicted quite accurately based on the tone of the ECB’s communications. In other words, the way in which the ECB communicates with the market allows us to draw conclusions about its future interest rate policies.”

The ECB’s tone as an instrument of monetary policy

The results of this study are particularly relevant for the central banks themselves, because they show that central banks can influence market participants’ expectations and appetite for risk through their choice of words. This makes the communication strategy of a central bank an instrument of monetary policy in its own right. Wagner also adds, “For market participants, our results mean that listening closely not just to what the ECB says but also how they say it can provide additional clues when making investment and financing decisions.”

Innovative research design

The ECB sets the current key interest rate approximately every six weeks and announces its decision in a short message issued at 1:45pm. At 2:15pm, the ECB holds a press conference, explaining the rationale behind its interest rate decision and giving its assessment of further economic developments. The researchers analyzed the ECB’s tone and generated a time series of changes in tone from one press conference to the next. This made 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.

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