Central Bank Communication and Exchange Rate Volatility: A GARCH Analysis

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1 Cenral Bank Communicaion and Exchange Rae Volailiy: A GARCH Analysis Radovan Fišer Insiue of Economic Sudies, Charles Universiy, Prague Roman Horváh* Czech Naional Bank and Insiue of Economic Sudies, Charles Universiy, Prague Absrac We examine he effecs of he Czech Naional Bank communicaion, macroeconomic news and ineres rae differenial on exchange rae volailiy using generalized auoregressive condiional heeroscedasiciy model. Our resuls sugges ha cenral bank communicaion has a calming effec on exchange rae volailiy. The iming of cenral bank communicaion seems o maer, oo, as financial markes respond more o he communicaion before he policy meeings han afer hem. Nex, macroeconomic news releases are found o reduce exchange rae volailiy, while ineres rae differenial seems o increase i. Keywords: cenral bank communicaion, exchange rae, GARCH. JEL Classificaion: E5, E58, F31. * We hank Tomas Holub and Filip Perold for helpful commens. The views expressed in his paper are no necessarily hose of he Czech Naional Bank. conacs: or

2 1. Inroducion A considerable effor has been spen in las one or wo decades o improve moneary policy ransparency and o provide a clear communicaion of moneary policy acions in order o manage inflaion expecaions effecively. While he auhoriaive survey on cenral bank communicaion by Blinder e al. (008) documens ha he effecs of cenral bank communicaion on financial markes were examined in many developed counries, bu he evidence on emerging marke economies is raher scan. 1 In his paper, we aim o bridge his gap and sudy he impac of cenral bank communicaion on exchange rae volailiy in one of small open emerging economies, he Czech Republic. We choose he exchange rae marke, as his marke is ofen of much larger imporance han oher segmens of financial markes for he economic flucuaions in emerging economies. More specifically, we are ineresed how he releases of oral and wrien policy saemens by he cenral bank (conrolling for macroeconomic news and oher facors) influence he exchange rae volailiy using generalized auoregressive condiional heeroscedasiciy (GARCH) model. Addiional hypohesis ha we wan o address in his shor policy paper is wheher he iming of cenral bank communicaion maers, i.e. wheher he financial markes respond o he communicaion more srongly before he moneary policy meeings han afer hem (see Ehrmann and Frascher, 007). The paper is organized as follows. Secion inroduces our empirical mehodology and daa. Secion 3 presens he resuls. Concluding remarks follow.

3 . Daa and Empirical Mehodology We use daily daa from 3 rd January 005 o 14 h February 007, which makes 536 observaions. The use of daily daa is jusified, if he main ineres is o invesigae he effeciveness of cenral bank communicaion (Jansen and de Haan, 005) as well as by he recen evidence suggesing ha i may akes several days unil news are fully absorbed by financial markes (Evans and Lyons, 005). The source of cenral bank communicaion and macroeconomic news variables is Reuers. Daily exchange rae and ineres rae daa are aken from he Czech Naional Bank (CNB). Our baseline specificaion is a GARCH(1,1) 3 process for exchange rae reurns, s = µ + ξ, (1) n 1 + γ 3σ 1 + φi CBi + ρ1news + ρ i= 1 σ = γ 1 + γ ξ indiff + ω j, () s denoes he log of CZK/EUR. 4 The consan erm in equaion (1), µ, shows he average rae of appreciaion or depreciaion. The error erm, ξ, of he mean equaion (1) is assumed o have a condiional variance, σ, specified by (). The condiional variance equaion includes in addiion o he consan, γ 1, ARCH erm, ξ -1, and GARCH erm, σ -1, he variables capuring he effec of cenral bank communicaion, CB i, macroeconomic news, news, and ineres rae differenial, indiff. We use he following variables o assess he effec of cenral bank communicaion: commen dummy variable ha akes a value of uniy on days, when a member of Czech Naional Bank Board commened verbally on he price sabiliy, economic oulook, ineres 3

4 raes or exchange rae. The Board comprises of seven members, all wih equal weigh in moneary policy rae seing process. The governor has a casing voe in case, when some members are missing a he moneary policy meeing and heir number is even. 5 iming is defined as he produc of commen and variable Г, which is a caegorical variable and akes value of 30 on he day of moneary policy meeing, 9 on he day before he meeing, 8 on wo days before he meeing and so on. In consequence, commens closer o moneary policy meeing ge greaer weigh. minues is a dummy variable wih uniary value on he day, when moneary policy minues are published (his is ypically 1 days afer moneary policy meeing). I follows from he definiion of our variables capuring he cenral bank communicaion ha we focus on wheher he cenral bank alked o he markes he raher han on inerpreing he conen of is communicaion. Therefore, he cenral bank communicaion variables are included only in he variance equaion and exchange rae is assumed o follow random walk. Macroeconomic news, news, is a dummy variable ha akes a value of uniy on days, in which scheduled macroeconomic news is released. Macroeconomic news dummy includes he releases of new daa on he Czech producer and consumer price indexes, GDP and balance of paymens. Ineres rae differenial, indiff, is a difference beween Czech and he euro area money marke rae (1YPRIBOR and 1YEURIBOR, respecively). In case of ick-by-ick daa, he impac of cenral bank communicaion and macroeconomic news on exchange rae volailiy should be non-negaive, as he new informaion hey conain affecs he exchange rae reurn. However, in case of daily daa, he expeced sign of hese variables is no clear-cu and he exising lieraure documens accordingly ha hey may boh 4

5 increase or decrease exchange rae volailiy (Jansen and de Haan, 005, Gabriel and Piner, 006, Ehrmann and Frazscher, 007) according o wheher i has a calming effec on he markes or no. Addiionally, greaer ineres rae differenial is likely o increase exchange rae volailiy (Kocenda and Valachy, 006). Larger differenial may signal he lack of synchronizaion of business cycle and subsequenly moneary policy and exchange rae is hus more likely o adjus. Table 1: Descripive Saisics s commen iming minues news indiff Mean Median Maximum Minimum Sandard deviaion Skewness Kurosis Jarque-Bera es [0.00] [0.00] [0.00] [0.00] [0.00] [0.00] Observaions Noes: p-values are repored in he brackes. Exchange rae series in levels. Nex, we presen he descripive saisics of key variables. Several issues are noeworhy. Czech cenral bank communicaion occurs on abou every enh day on average, while macroeconomic announcemens are released more common (wih he mean of 0.1). Minues occur monhly, as he frequency of moneary policy meeings is monhly in our sample period, oo (as here are business days on average per monh, he mean is 0.05). Czech ineres raes were on average nearly 0.5 percenage poin below he euro area during sample period. 5

6 Char 1 presens he frequency of cenral bank communicaion. As he moneary policy meeing is ypically held on Thursday, he resuls indicae ha he frequency of communicaion is much lower in he week he moneary policy meeing is held (see he frequencies on he days 1-3 in Char 1). The communicaion is he mos inense from 10 o 6 days before he moneary policy meeing akes place. This finding is in line wih evidence on he Bank of England, European Cenral Bank and he U.S. Federal Reserve (see Ehrmann and Frazscher, 007), where communicaion is more common, as he meeing comes closer. On he oher hand, in conras o hese cenral banks, we can see ha he Czech cenral bank communicaion is no more frequen afer he moneary policy meeing. We suppose ha his reflecs he fac ha he CNB pus a lo of effor in explaining heir ineres rae decision and risk scenarios a he press conference jus afer he moneary policy meeing was held. Char 1: Frequency of Cenral Bank Communicaion Noe: Horizonal axis measure he days before moneary policy meeing. Verical axis gives he frequency. 3. Resuls Table presens our resuls on he deerminans of exchange rae volailiy. We find ha ha cenral bank communicaion ends o decrease exchange rae volailiy, i.e. his suppors he 6

7 view ha cenral bank aims o decrease he noise in he financial markes (Blinder e al., 008). The finding complies wih Jansen and de Haan (005) and Gabriel and Piner (006), who also find ha he exchange rae volailiy of EUR/USD and HUF/EUR, respecively is lower on he day, when cenral bank communicaes is views on he economy o he public. In addiion, he resuls sugges ha iming of cenral bank communicaion seems o maer, oo. 6 Similarly, Ehrmann and Frazscher (007) sudy he iming of cenral bank communicaion for he case of Bank of England, European Cenral Bank and he U.S. Federal Reserve Bank. Despie hey define he measure of iming of cenral bank communicaion differenly (primarily using various dummy variables and ineracing hem wih he model coefficiens), heir resuls sugges ha he iming of communicaion is informaive for a whole variey of financial asses including he exchange rae. We also find ha he effec of cenral bank minues is no clear, as he sign of coefficien differs across he specificaions. The effec of macroeconomic news is somewha surprising; i ends o decrease exchange rae volailiy. This may reflec he fac he here is higher uncerainy in emerging markes and news is likely o have calming effec on he markes. Neverheless, his effec is found also in some oher sudies in developed counries such as Kim e al. (004), who repor ha DEM/USD exchange rae volailiy decreases on he day he news on producer price index is released. Greaer ineres rae differenial is found o increase exchange rae volailiy (see also Kocenda and Valachy, 006, for furher evidence in he case of Czech Republic). 7

8 Table : The Effec of Cenral Bank Communicaion on Exchange Rae Volailiy s = µ + ξ n 1 + γ 3σ 1 + φi CBi + ρ1news + ρ i= 1 σ = γ 1 + γ ξ indiff + ω j (1) () (3) (4) (5) µ [0.00] [0.00] [0.00] [0.00] [0.00] γ *** 0.000*** 0.000*** 0.000*** 0.000*** [0.00] [0.00] [0.00] [0.00] [0.00] γ 0.15*** 0.15*** * 0.15* [0.05] [0.05] [0.01] [0.08] [0.09] γ *** 0.60*** 0.95*** 0.60*** 0.60*** [0.09] [0.10] [0.0] [0.15] [0.17] φ 1 (commen ) -3.37*** -3.4** [1.19] [1.31] φ (iming ) -0.15** -0.16** [0.07] [0.06] φ 3 (minues ) 4.78*** -4.6** -4.80* [1.1] [.33] [.61] ρ *** -3.59* -0.99** -3.64** -3.57* [0.91] [.18] [0.40] [1.85] [.06] ρ 1.81*** *** 1.86* 1.79 [0.70] [1.37] [0.19] [1.09] [1.38] L-B(10), RES L-B(10), SQRES Schwarz inf. cri N Noes: We repor sandard errors in parenhesis and Ljung-Box Q-saisics of he 10 h lag for sandardized and squared residuals. ***, **, and * - denoes significance a 1 percen, 5 percen, and 10 percen, respecively. The value of φ 1, φ, φ 3, ρ 1 and ρ are muliplied by

9 4. Concluding remarks We analyze he imporance of cenral bank communicaion, macroeconomic news and ineres rae differenial on exchange rae volailiy in he Czech Republic using GARCH framework. Our main resuls are as follows. Cenral bank communicaion ends o decrease exchange rae volailiy, i.e. his suppors he view ha cenral bank aims o decrease he noise in he financial markes. The iming of cenral bank communicaion seems o maer, oo. Macroeconomic news is found o decrease exchange rae volailiy. This may reflec he fac he here is higher uncerainy in emerging markes and news is likely o have calming effec on he markes. 9

10 References Blinder, A. S., Ehrmann, M., Frazscher, M., Haan, J. D., and Jansen, D.-J. (008). Cenral Bank Communicaion and Moneary Policy: A Survey of Theory and Evidence. Journal of Economic Lieraure, 46(4), Bollerslev, T. (1986). Generalized Auoregressive Condiional Heeroskedasiciy. Journal of Economerics, 31, Bulir, A. and Smidkova, K. (007). Sriving o Be Clearly Open and Crysal Clear : Moneary Policy Communicaion of he CNB. Finance a uver Czech Journal of Economics and Finance, 57 (11-1), Ehrmann, M. and Frazscher, M. (007). The Timing of Cenral Bank Communicaion. European Journal of Poliical Economy, 3 (1), Evans, M. D. and Lyons, R. K. (005). Do Currency Markes Absorb News Quickly?. Journal of Inernaional Money and Finance, 4 (), Gabriel, P. and Piner, K. (006). The Effec of he MNB's Communicaion on Financial Markes. MNB Working Papers 006/9, Magyar Nemzei Bank (The Cenral Bank of Hungary). Jansen, D.-J. and De Haan, J. (005). Talking Heads: The Effecs of ECB Saemens on he Euro-Dollar Exchange Rae. Journal of Inernaional Money and Finance, 4 (), Kim, S.-J., McKenzie, M. D., and Faff, R. W. (004). Macroeconomic News Announcemens and he Role of Expecaions: Evidence for US Bond, Sock and Foreign Exchange Markes. Journal of Mulinaional Financial Managemen, 14 (3), Kocenda, E. and Valachy, J. (006). Exchange Rae Volailiy and Regime Change: A Visegrad Comparison, Journal of Comparaive Economics, 34(4), Kohn, D. L. and Sack, B. P. (003). Cenral Bank Talk: Does I Maer and Why? Finance and Economics Discussion Series , Board of Governors of he Federal Reserve Sysem (U.S.). Rozkru, M., Rybinski, K., Szaba, L., and Szwaja, R. (007). Ques for Cenral Bank Communicaion: Does I Pay o Be "Talkaive"? European Journal of Poliical Economy, 3,

11 1 See also Kohn and Sack (003) on why and how he cenral bank communicaion maers for financial markes. Rozkru e al. (007) sudy he impac of cenral bank communicaion on he ineres rae in a group of Cenral European counries. Anecdoal evidence on moneary policy communicaion of he Czech Naional Bank is provided by Bulir and Smidkova (007). 3 Noe ha we also esimaed GARCH model wih higher lags, bu failed o find hem significan. In addiion, as bad news are someimes found o maer more in financial markes, we also examined asymmeric GARCH models such as hreshold auoregressive condiional heeroscedasiciy TARCH model or exponenial generalized auoregressive condiional heeroscedasiciy EGARCH, bu did no find any asymmery. These resuls are available upon reques. See Bollerslev (1986) on GARCH modelling. 4 Eq. (1) is defined in levels, as we can rejec he null hypohesis of uni roo in he level of exchange rae. 5 For his reason, we assess wheher he communicaion of governor maers more han he communicaion of oher members. We consruc wo dummy variables for he communicaion of governor and oher Board members. Conrolling for oher facors, we find he coefficien on governor s communicaion larger han he coefficien on oher member s communicaion, bu he difference beween he respecive coefficiens is no saisically significan. 6 The correlaion coefficien beween iming and commens is 0.96 and herefore, we do no include hese wo variables ogeher in he regression because of mulicollineariy. 11

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