📝ECB: Model Shows Central Bank Communication Drove EUR/USD Lower

What central banks say can influence prices on financial markets and, ultimately, how the economy evolves. That makes communication an important tool of monetary policy as it helps clarify policymakers’ reaction function and steer expectations

We found that the overall tone of the Federal Reserve’s (Fed) and the European Central Bank’s (ECB) meeting communication turned increasingly hawkish around early 2021 and mid-2021, respectively (Chart A – blue lines). This was about a year before the two central banks started to actually raise rates.

The hawkish shift in overall tone happened despite the economic outlooks being seen as relatively weak and the use of forward guidance on both sides of the Atlantic at that time (consistent with a muted contribution of the policy component). This finding is based on our topic-tone model – similar in spirit to that developed by Fed colleagues in Gardner et al. (2022). This model quantifies the directional tendency of official ECB and Fed communication of monetary policy decisions and press conference transcript.

Notably, the shift in the overall tone measured by our topic-tone model was predominantly driven by changes in the tone of communication on the inflation outlook and monetary policy in both the euro area and the United States (yellow and red bars). On the other hand, the assessment of the economic outlook turned increasingly dovish over the course of 2022 (green bars).

We find that differences in policy tone between the ECB and Fed help to explain changes in the EUR/USD exchange rate. In addition to the communication following policy meetings, communications between such meetings, e.g. speeches by policymakers, can also affect financial markets. Chart C plots the difference in policy tone between the ECB and Fed based on both meeting and inter-meeting communications. Including a broader set of communication events allows for a more nuanced assessment of the relative dynamics between the two jurisdictions. In early 2021, the Fed started to communicate in more hawkish terms relative to the ECB, according to our 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. - ECB Blog