Working Paper Monetary policy communication under inflation targeting: Do words speak louder than actions?

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1 econsor Der Open-Access-Publikaionsserver der ZBW Leibniz-Informaionszenrum Wirschaf The Open Access Publicaion Server of he ZBW Leibniz Informaion Cenre for Economics Demiralp, Selva; Kara, Hakan; Özlü, Pınar Working Paper Moneary policy communicaion under inflaion argeing: Do words speak louder han acions? Koç Universiy-TÜSİAD Economic Research Forum Working Paper Series, No Provided in Cooperaion wih: Koç Universiy - TÜSİAD Economic Research Forum, Isanbul Suggesed Ciaion: Demiralp, Selva; Kara, Hakan; Özlü, Pınar (2011) : Moneary policy communicaion under inflaion argeing: Do words speak louder han acions?, Koç Universiy- TÜSİAD Economic Research Forum Working Paper Series, No This Version is available a: hp://hdl.handle.ne/10419/ Nuzungsbedingungen: Die ZBW räum Ihnen als Nuzerin/Nuzer das unengelliche, räumlich unbeschränke und zeilich auf die Dauer des Schuzrechs beschränke einfache Rech ein, das ausgewähle Werk im Rahmen der uner hp:// nachzulesenden vollsändigen Nuzungsbedingungen zu vervielfäligen, mi denen die Nuzerin/der Nuzer sich durch die erse Nuzung einversanden erklär. Terms of use: The ZBW grans you, he user, he non-exclusive righ o use he seleced work free of charge, erriorially unresriced and wihin he ime limi of he erm of he propery righs according o he erms specified a hp:// By he firs use of he seleced work he user agrees and declares o comply wih hese erms of use. zbw Leibniz-Informaionszenrum Wirschaf Leibniz Informaion Cenre for Economics

2 KOÇ UNIVERSITY-TÜSİAD ECONOMIC RESEARCH FORUM WORKING PAPER SERIES MONETARY POLICY MUNICATION UNDER INFLATION TARGETING: DO WORDS SPEAK LOUDER THAN ACTIONS? Selva Demiralp Hakan Kara Pınar Özlü Working Paper 1128 Ocober 2011 KOÇ UNIVERSITY-TÜSİAD ECONOMIC RESEARCH FORUM Rumelifeneri Yolu Sarıyer/Isanbul

3 Moneary policy communicaion under inflaion argeing: Do words speak louder han acions? 1 Selva Demiralp 2 Koç Universiy Rumeli Feneri Yolu, Sariyer, Isanbul, 34450, Turkey Hakan Kara Cenral Bank of Turkey Research and Moneary Policy Deparmen Isiklal Cad. No:10 Ulus Ankara, 06100, Turkey Pınar Özlü Cenral Bank of Turkey Research and Moneary Policy Deparmen, Isiklal Cad. No:10 Ulus Ankara, 06100, Turkey May 2011 Absrac This paper assesses he effeciveness of moneary policy communicaion of he Cenral Bank of Turkey (CBT) by quanifying he informaion conen of he policy saemens released righ afer he monhly Moneary Policy Commiee meeings. Firs, we quanify he signal regarding he nex ineres rae decision and ask wheher CBT s words mach is deeds, i.e., wheher communicaion improves predicabiliy using he Auoregressive Condiional Hazard model. Our findings sugges ha he role of saemens in predicing he nex policy move have srenghened following he adopion of full-fledged inflaion argeing (IT) regime. Second, we idenify he surprise componen of policy communicaion direcly from marke commenaries and assess is impac on he erm srucure of ineres raes. We find ha he response of he yield curve o policy saemens have become highly significan for he unanicipaed changes in he moneary policy communicaion and he relaive imporance of communicaion in driving marke yields has increased hrough ime. JEL Codes: E52, E58 Keywords: Cenral Bank Communicaion, Predicabiliy, Transparency 1 The views expressed in his paper are hose of he auhors and do no necessarily reflec he opinions of he Cenral Bank of Turkey. We would like o hank Michael Ehrmann, Jacob de Haan, Refe Gurkaynak, Sevim Kosem Alp, Michael Lamla, he conference paricipans a he Cenral Bank of Turkey, De Nederlandsche Bank, ACES session in ASSA 2011 meeings, and he second inernaional conference of he Turkish Economic Associaion. Demiralp s research was funded by he Turkish Academy of Sciences (TUBA). 2 Corresponding auhor. Fax: Phone:

4 1. Inroducion Since he early 1990s, he conduc of moneary policy has shifed from secrecy owards more ransparency. The main reason behind his global rend was he increasing undersanding ha ransparency can improve he effeciveness of policy (see Woodford, 2003). This approach has highlighed he role of communicaion in moneary policy. Accordingly, he academic lieraure explored his opic exensively over he las fifeen years (see e.g. Blinder e al., 2008, Ehrmann and Frazcher, 2007a-d, Reeves and Sawicki, 2007, Rozkur e al., 2007, Faum and Scholnick, 2008, Beine e al., 2009, Chulia e al., 2010, Surm and de Haan, 2011, among ohers). Cenral banks ofen use shor-erm ineres raes as heir main operaional insrumen. However, shor-erm raes hardly maer for he broader objecives of he cenral banks such as fuure inflaion or prospecive economic aciviy, as privae consumpion and invesmen decisions are mainly driven by longer erm ineres raes. Communicaion emerges as a naural bridge in his respec, which enables cenral banks o seer privae secor expecaions abou heir fuure acions and affec he longer end of he yield curve. Moneary policy communicaion ypically akes wo main forms. The firs one is communicaion hrough official documens such as inflaion repors and policy announcemens ha accompany ineres rae decisions. The second form of communicaion involves speeches, presenaions or inerviews by he policymakers during he iner-meeing period. In his paper, we focus on cenral bank communicaion hrough policy saemens accompanying he ineres rae decisions. 1

5 Two ypes of informaion are released in a policy saemen. The firs piece of informaion is he ineres rae decision iself. In a seminal paper on his opic, Kuner (2001) highlighed ha following he ineres rae announcemens, marke paricipans only respond o he unanicipaed componen of he ineres rae decision. The second piece of informaion released wih announcemens, which is he main scope of his paper, is he forward looking message he communicaion componen. There have been numerous sudies focusing on he moneary policy communicaion and is impac on financial markes. Jus like he decision iself, policy communicaion should have an impac on financial markes only if i has some surprise conen. Ye, he lieraure has no always been very careful in underlining he unanicipaed componen of policy communicaion due o he challenging naure of his ask. The earlier sudies ha invesigaed he effecs of policy saemens aemped o use he informaion conen of policy saemens direcly o assess he impac of communicaion on financial markes. However, hese papers did no propose a sysemaic idenificaion procedure o measure he surprise in policy communicaion, and hus, hey were mosly silen on he mehodology on he signal exracion process. For example, alhough Guhrie and Wrigh (2000) invesigae he impac of communicaion surprises on financial indicaors, he auhors do no explain in deail how hey acually compue he surprises. Kohn and Sack (2004) ge around he difficulies of quanifying communicaion by focusing on he impac of policy saemens on he volailiy of financial asses, implicily assuming ha a leas some par of he policy saemen carries an unanicipaed componen o affec financial markes. 2

6 In order o measure he surprise conen of he communicaion, more recen sudies esimae he unanicipaed componen of communicaion using economeric echniques (see e.g. Gurkaynak e al., 2005, Andersson e al., 2006, Rosa and Verga, 2007, Rosa and Verga, 2008, Rosa, 2011). Neverheless, hese echniques assume a paricular law of moion for he formaion of expecaions and hey provide an indirec measure of policy surprises. One possible explanaion for he scarciy of papers ha sudy he impac of he unanicipaed componen of policy saemens is he inheren challenge in measuring he surprise due o lack of expecaions surveys on he wording of he saemens. Indeed, Ehrmann and Frazscher (2007) sae ha Ideally one would wan o sudy he response of financial markes o he surprise componen conained in a given communicaion. However consrucion of a proxy of marke expecaions is no sraighforward, for insance no survey daa like in he case of macroeconomic announcemens or moneary policy decisions are available. There are no surveys bu here are marke commenaries. This paper conribues o he ever growing lieraure on cenral bank communicaion by using a novel and simple mehodology o measure he unanicipaed componen of policy saemens: we idenify he saemen surprises direcly from marke commenaries published before and afer he release of monhly Moneary Policy Commiee (MPC) saemens of he Cenral Bank of Turkey (CBT). 3 In mos cases marke players no only explicily menion wheher he 3 Clearly, monhly saemens are no he only communicaion ools. There are oher forms of communicaion ools available such as speeches/inerviews by he governor or he members of he moneary policy commiee. However, in he case of CBT, inflaion repors and monhly policy saemens are by far he mos acively used communicaion ools of moneary policy (see he CBT s main policy 3

7 saemen was expeced bu also implicily indicae in which direcion hey were surprised. Therefore, comparing he commens wrien by cenral bank wachers before and afer he meeing allows us o pin down he surprise componen of he communicaion. Using he surprise componens derived from marke commenaries, we measure he impac of cenral bank communicaion over he yield curve. We assess wheher moneary policy communicaion affecs expecaions of fuure ineres raes in he desired direcion via is reflecions on he yield curve. We find ha policy saemens play a significan role in affecing he yield curve, independen of he curren ineres rae decision. In paricular, he yield curve on average shifs by an addiional 20 basis poins over he medium erm following a surprise change in he policy sance. The second conribuion of he paper is an evaluaion of he poenial effeciveness of he sysemaic componen of moneary policy communicaion in Turkey. We quanify he CBT s implied signal regarding he nex ineres rae decision and assess wheher cenral bank communicaion has acually improved he predicabiliy of he ineres rae decisions afer he adopion of a more clear and ransparen policy framework wih he inflaion argeing regime. For each documen, we rack he changes sraegy documen a hp:// In his paper, we resric our aenion only o he monhly policy saemens raher han he Inflaion Repor because of he lack of sufficien daa for marke commenaries regarding he inflaion repor. In he early years of he inflaion argeing period, marke paricipans hardly commened on he inflaion repors before and afer he release. Because our idenificaion of communicaion surprises depends on hese commenaries, we excluded inflaion repors from our analysis, even hough hese repors are one of he main communicaion ools of CBT ogeher wih monhly moneary policy commiee saemens. 4

8 in he wording on fuure policy rae so as o capure he signal regarding he nex ineres rae decision. Uilizing hese signals via a forecasing model developed for irregularly spaced evens, we esimae wheher he CBT s words mach is deeds. The resuls sugges ha cenral bank communicaion provided very accurae signals regarding he nex ineres rae decision in Turkey. Especially afer he implemenaion of he inflaionargeing regime, he informaion conen of policy saemens improved he predicabiliy of he CBT subsanially, suggesing ha he sysemaic componen of cenral bank communicaion has also become poenially more effecive. The remainder of his paper is organized as follows: The nex secion provides a brief evaluaion of he hisory of cenral bank communicaion in Turkey. Secion hree discusses our idenificaion sraegy while secion four presens our empirical resuls. The fifh secion concludes. 2. A Brief Hisory of Moneary Policy Communicaion in Turkey Moneary policy of he Cenral Bank of Turkey became increasingly more ransparen since 2001 wih many imporan srucural changes ransforming he policymaking environmen. In his secion, we provide a brief hisory of he key developmens affecing he policy-making process of he CBT and he relevan communicaion sraegy during his period. 4 4 We resric our aenion o he period , when he CBT had a single objecive of price sabiliy and used shor erm ineres rae as he unique policy insrumen. Therefore, we exclude he recen period (saring wih he las quarer of 2010) when he CBT adoped financial sabiliy as a supplemenary objecive and began o uilize addiional policy insrumens such as reserve requiremen raios. Assessing he communicaion issues relaed o his episode is beyond he scope of his paper. 5

9 In order o highligh he milesones affecing he communicaion sraegy of moneary policy, we divide our sample ino hree pars: (i) : implici inflaion argeing wih unknown decision daes, (ii) 2005: implici inflaion argeing wih fixed decision daes bu no explici signal regarding fuure policy pah, (iii) 2006-o-dae: fullfledged inflaion argeing: explici informaion regarding fuure policy pah hrough policy announcemens and inflaion repors : Implici Inflaion Targeing wih Unknown Decision Daes 5 Turkey adoped inflaion argeing and free floa exchange rae regime in February The new Cenral Bank Law was enaced in May 2001, which defined he main goal of he CBT as achieving price sabiliy. Along wih he legislaion of he new law, CBT was graned wih insrumen independence and he shor erm ineres raes became he main operaional insrumen of moneary policy. The Law also defined a new decision making body he Moneary Policy Commiee (MPC). The main ask of he MPC is o formulae he moneary policy sraegy, which includes seing he policy raes and communicaing fuure moneary policy. A he iniial sages of he new regime, moneary policy lacked conrol over he longer end of he yield curve, because under high public deb and shor mauriies, he volaile risk premium manifesed iself as excess variabiliy in he exchange raes. 5 Implici inflaion argeing can be defined as a period under which inflaion arges are announced o he public, bu no he regime and is deails as such. I involves he counry acing as if inflaion argeing were in place wihou a formal adopion of he regime. Typically, he cenral bank would also have oher inermediae arges, as Turkey did beween in he form of moneary arges. 6

10 Increased volailiy in exchange raes coupled wih fas and high exchange rae passhrough inheried from he exchange rae argeing regimes made forecasing inflaion even more difficul, limiing he forecas horizon o a mere couple of monhs. Therefore, CBT was no able o provide a medium erm perspecive regarding fuure inflaion or moneary policy. Under hese circumsances, saemens following he ineres rae decisions were mainly focused on jusifying he acions raher han providing explici informaion regarding he fuure course of policy raes. 6 In oher words, he forwardlooking componen of he communicaion, which is he main ineres of his sudy, was limied. Following he examples of he major cenral banks across he world, CBT sared announcing ineres rae decisions wih an accompanying saemen, alhough hese saemens a he beginning did no involve informaion regarding he fuure course of policy raes. Moneary policy saemens during mainly focused on he implemenaion of he srucural reforms especially regarding fiscal policy, which would suppor he decline in risk premiums. The main driver of inflaion expecaions during his period was fiscal policy (see Celasun e al. 2004). Therefore, he sraegy of he CBT during his period was o reward he governmen wih policy rae cus, should he srucural reform and fiscal consolidaion make progress. Since sovereign risk premium largely refleced he marke s percepions of he fiscal sance, he CBT closely moniored he risk premiums in seing he policy raes. 6 See Kara (2008) for an accoun of he CBT s communicaion and decision-making process during implemenaion of he implici inflaion argeing regime. 7

11 Overall, in he afermah of he 2001 crisis, moneary policy in he firs hree years of implici inflaion argeing (he period beween 2002 and 2004) can be characerized as a highly discreionary and raher opaque decision-making process: Since he economy was under a sabilizaion program wih many srucural changes, he saemens mainly concenraed on srucural reforms, fiscal policy, and hence he risk premiums, raher han broad economic analysis regarding he business cycle. Timing of he policy decisions was no predicable, and he saemens focused on jusifying he decision iself, wihou providing sysemaic informaion on he fuure course of moneary policy. The basic informaion provided in hese saemens was ha he coninuaion of he ineres rae cus would depend on he implemenaion of srucural reforms. While he meeing calendar was no known in advance, policy decisions were announced wih an accompanying saemen a 10:00 AM in he morning : Adoping Fixed Decision Daes The CBT envisioned implici inflaion argeing as a ransiion period for fullfledged inflaion argeing, during which he communicaion, ransparency, and he insiuional seup would be enhanced gradually. The decision-making process shifed o a more predicable and sysemaic seup in 2005 wih he adopion of pre-announced fixed decision daes. The MPC meeings, which were held on he 8 h of each monh, were followed by a promp release of a policy saemen oulining he raionale behind he decisions, as well as providing he (consensus) opinion of he MPC. The saemen underlying he decisions was made public a 9:00 AM on he day afer he meeing. These saemens no only jusified he immediae decisions bu also provided signals 8

12 regarding he fuure course of ineres raes. Alhough he signal conen of he saemens was weak a he beginning, i gained srengh hrough ime. As ime wen by, more and more informaion was shared wih he public, and he abiliy of CBT o ac as an expecaions manager improved considerably o-dae: Moneary Policy Communicaion under Inflaion Targeing The Cenral Bank of Turkey adoped full-fledged inflaion argeing a he beginning of The regime brough many innovaions in erms of decision-making process and he role of communicaion. In erms of communicaion aspecs, here were wo main innovaions: Firs, he CBT sared o publish he medium erm inflaion forecass along wih some qualiaive informaion regarding he fuure policy pah. Second, he CBT enhanced he forward looking informaion conen of he policy saemens, providing more specific guidance regarding he revisions in he policy sance. In sum, he implemenaion of full-fledged inflaion argeing, coupled wih he new sraegy adoped by he MPC, has increased he forward looking componen of he moneary policy. Wih he adopion of full-fledged inflaion argeing, monhly MPC saemens became one of he main ools of moneary policy communicaion. 7 The MPC saemen, 7 In addiion o policy saemens, here are oher communicaion ools o inform he public. Examples of such ools are he biannual esimony of he Governor before he Council of Minisers and he Planning and Budge Commission of he Grand Naional Assembly of Turkey; monhly Price Developmens repors issued on he following working day of he release of inflaion figures; biannual Financial Sabiliy Repor ; press releases, presenaions and speeches made by he Cenral Bank auhoriies in Turkey and abroad. In addiion, working papers, bookles, echnical noes, conferences and workshops arranged by he 9

13 published immediaely afer he decision, ypically consiss of wo main paragraphs. The firs paragraph provides MPC s assessmen of economic condiions relevan for inflaion oulook. The second paragraph is he policy paragraph, which direcly elaboraes on he MPC s view of he likely course of fuure ineres raes. We uilize he informaion conen of boh paragraphs while quanifying he moneary policy communicaion. Timing of he MPC Saemens Since 2005, meeings are based on a pre-announced schedule wih an annual imeable. In 2005, he meeings were held on he 8 h of each monh or he closes business day if he 8 h corresponded o a weekend. The policy saemens were published he nex morning a 9:00 AM. In 2006, MPC meeings were held a daes close o he end of monh, whereas from 2007 o presen he meeings are scheduled around mid-monh. 8 Since 2006, he ineres rae decision and he relaed MPC saemen is announced by he Cenral Bank in a press release a 7:00 PM on he same day and posed on he websie of he Bank. 3. Measuring Communicaion Cenral bank communicaion is a broad concep. Alhough here are many differen reasons why cenral banks communicae wih he public, cenral bank Bank also work as differen means of he communicaion policy. However, hese communicaion ools generally do no reveal exra informaion oher han hose disseminaed hrough inflaion repors and monhly policy saemens. 8 There were wo iner-meeings of he MPC ha ook place in June 2006, following he financial urmoil riggered by a sell-off in emerging markes. 10

14 communicaion effors in general concenrae on wo inerrelaed issues: (i) anchoring long erm inflaion expecaions, (ii) increasing he effeciveness of he moneary policy. In his paper, we focus on he laer. Effeciveness of he moneary policy depends on he conrol over he yield curve. This basically boils down o communicaing he fuure pah of he policy raes, aiming o shape up he erm srucure of marke ineres raes in he desired direcion. In his conex, his paper has wo goals: Firs, we assess wheher cenral bank communicaion affecs he predicabiliy of fuure policy rae decisions. Second, we invesigae wheher he communicaion has an impac on he yield curve, afer conrolling for he surprise componen of he rae decision. To ackle hese ambiious asks, we consruc a daabase by quanifying boh he informaion regarding he policy decisions implied in he CBT s main published documens and he surprises in policy saemens as perceived by he marke paricipans. We se up wo differen ypes of communicaion variables aiming o capure (i) he direcion of he nex ineres rae decision, and (ii) surprise in communicaion. The documens we use o exrac he forward looking signals regarding fuure moneary policy are he monhly saemens accompanying ineres rae decisions. Clearly, here are oher forms of verbal or wrien communicaion ools available such as speeches/inerviews by he governor or oher members of he MPC. Neverheless, during he inflaion argeing period, inermeeing speeches or inerviews were no commonly used as acive ools o manage he marke s expecaions of fuure policy. The moneary policy sraegy of he Cenral Bank of Turkey was mainly communicaed via monhly MPC saemens and inflaion repors. This behavioral paern mainly sems from MPC s collegial srucure: MPC members speak in harmony regarding moneary policy, and 11

15 opposing views (if any) among he members are no disclosed. When decisions are communicaed as a consensus view, i is naural o disseminae he key messages regarding fuure ineres raes hrough he main insiuional documens such as inflaion repors and monhly policy saemens. Therefore, he speeches and inerviews by he MPC members (including he governor) during he inermeeing period do no ypically reveal addiional informaion oher han hose indicaed in he official documens. 9 Accordingly, we resric our aenion o he monhly MPC saemens, which are he mos racable sources for quanifying he signal regarding he nex ineres rae decision along wih he inflaion repors. We leave he ask of measuring he communicaion impac of inflaion repors for fuure sudies Quanifying he Signal Regarding he Nex Policy Decision One of he goals of his paper is o assess wheher he CBT s words mach is deeds. In order o answer his quesion, we need o quanify he signal embedded in he policy saemen regarding he nex ineres rae decision. In his secion, we describe he way we consruc he variable indicaing he bias regarding he nex ineres rae decision, namely, communicaion variable, D. To his end, we classify all monhly MPC saemens according o heir implicaions for he likely pah of ineres raes over he near erm. We classify saemens ino hose ha indicae an inclinaion owards raising policy raes for he nex meeing, hose ha sugges a rae cu and hose ha are neural. We also quanify he srengh of he signal given by he MPC. Therefore, he ighening and 9 There are some excepional occasions when he Governor or he MPC members aemped o change he misundersandings regarding he policy saemens; however such cases are rare. 12

16 he easing bias are furher classified ino wo sub-caegories as weak and srong. Nex, all he classificaions are coded on a numerical scale. We rely on he following principles in generaing indicaor variables for each saemen: (i) If a need for increasing (decreasing) he overnigh iner-bank borrowing rae is expressed explicily in he saemen or if here are judgmens abou economic analysis end/or inflaion prospecs ha clearly imply he need of a rae hike (cu) in he shor erm, hen he variable is assigned he value 2 (-2), (ii) If a need for increasing (decreasing) he overnigh iner-bank borrowing rae is expressed vaguely in he saemen or if here are judgmens abou he economic analysis and/or inflaion ha weakly imply he need of a rae hike (cu) in he shor erm, hen he variable is assigned he value 1 (-1), (iii) If he evaluaions in he saemen do no imply he need of a change in he policy rae over he near fuure, he variable is assigned he value zero. Accordingly, one of he five poenial values is assigned for each wrien saemen as follows: D = srong ighening inclinaion weak ighening inclinaion signaling no change weak easing inclinaion srong easing inclinaion The communicaion variable, D, consruced in he above manner racks changes in he saemens regarding he fuure course of moneary policy. Indeed, even small wording changes in he saemen may sugges a change in he srengh of he signal 13

17 regarding he nex policy decision. To illusrae his case, consider he following examples. Example 1: On is February 2008 meeing, CBT cu ineres raes by 25 basis poins. The following paragraph shows he relevan secion of he accompanying policy saemen regarding he nex ineres rae decision: The iming of furher easing will depend on developmens regarding global marke condiions, exernal demand, fiscal policy implemenaion, and oher facors affecing he medium erm inflaion oulook. (emphasis added) The saemen explicily menions a rae cu bu emphasizes ha he iming will depend on developmens. Therefore, we inerpre his as a relaively weak signal of a furher rae cu and se D = Example 2: In he March 2009 meeing, he CBT cu he ineres raes by 100 basis poins. The following informaion was released wih he policy saemen: The Cenral Bank will coninue o ake he necessary measures o conain he adverse effecs of he global financial urmoil on he domesic economy, provided ha hey do no conflic wih he price sabiliy objecive. Looking forward, he Commiee envisages ha he nex rae cu may be measured, and ha i may be necessary for he moneary policy o mainain an easing bias for a considerable period. (emphasis added) 10 A naural quesion one migh ask a his poin is how confiden we are regarding he inerpreaion of hese nuances in he policy saemens. We believe ha our inerpreaion is very close o he rue inenions of he policy makers because we discussed and checked he validiy of our inerpreaion wih he officials a he CBT. 14

18 Here he MPC makes i clear ha anoher rae cu is highly likely. In his case, we se D =-2 o accoun for he sronger signal released by he CBT. Table A1 in he appendix provides furher examples from he policy saemens regarding he preparaion of D while he hird column in Table 1 shows he values aained by he variable for he full sample. D Surprise in Communicaion One of he main goals of his paper is o assess wheher cenral bank communicaion has an impac on he erm srucure of ineres raes. The indicaor variable consruced in he previous secion does no help o answer his quesion, as we need o pin down he surprises in policy saemens in order o idenify he impac of he communicaion on asse prices. Therefore, in his secion, we consruc a separae indicaor variable o deec unanicipaed changes in he policy saemens by direcly going hrough marke commenaries associaed wih each policy saemen. Revisions in he wording of policy saemens are closely wached by marke paricipans o exrac he forward looking informaion regarding he policy pah. Marke paricipans form heir expecaions abou he conen of hese saemens and adjus heir posiions accordingly. As a resul, if we wan o measure he impac of policy saemens on asse markes, we need o idenify hose cases where he changes in he policy saemen were no anicipaed by marke paricipans. In order o idenify wheher he saemen involves any surprise, we use he marke commenaries ha are regularly published before and afer he saemen/repor is released. To his end, we use he daabase of Reuers News, a newswire service ha is 15

19 frequenly used by financial marke paricipans. We search his daabase for he marke paricipans commenaries boh before and afer he policy decision. Prior o he meeing, he marke paricipans no only repor heir expecaions on policy decisions bu occasionally menion he messages hey expec he CBT o deliver wih respec o he fuure course of ineres raes. We check all marke commenaries repored before he meeing o undersand he expecaions wih respec o he saemen. Then, we compare hese expecaions wih marke commenaries repored afer he policy decision. We seek o deec surprises in communicaion perceived by he marke paricipans, such as an unexpeced change in he MPC s assessmen of he economic condiions or he moneary policy oulook. In general, marke commenaries do no elaborae much on he expeced policy saemen before he meeing. However, if he saemen delivers an unexpeced message, i is menioned in he commenaries following he meeing. I is also possible o idenify he direcion of he surprise (wheher he saemen was more hawkish or dovish han expeced) direcly from he marke commenaries. Alhough we are no able o measure he size of he marke surprise, we neverheless believe ha his mehodology of idenifying he surprises is sill innovaive and useful. Accordingly, we rely on he following principles in generaing he indicaor variable o capure he surprise change in he policy saemen ( Surp ST ): (i) If comparison of he marke repors/commenaries before and afer he MPC meeings reveals ha he saemen was more hawkish (dovish) han marke expecaions, hen he variable is assigned he value 1 (-1). 16

20 (ii) If he marke repors/commenaries do no indicae a surprise in communicaion, hen he variable is assigned he value Surp ST = The saemen was more hawkish han expeced No Surprise Thesaemenwas more dovish han expeced In order o illusrae our mehodology, look a he marke commenary following he policy saemen in July 2007: MPC s acion as o leave he ineres raes unchanged as expeced bu he surprise announcemen ha gradual easing may sar in he las quarer is expeced o pull he marke ineres raes and he exchange raes down (emphasis added) In our analysis, we inerpre ha he policy saemen in July 2007 were perceived as more dovish han expeced for marke paricipans, and hus we se he surprise variable Surp ST expeced. = -1, alhough he policy decision iself (leaving raes consan) was compleely 11 According o our mehodology, if he marke commenaries do no indicae any unanicipaed policy move, we inerpre his as no surprise. This may be due o wo reasons: (i) marke paricipans correcly anicipaed he changes in he wording of he saemen (ii) marke paricipans did no noice he implicaions of he changes in he wording of he saemen. Unforunaely, our mehodology canno differeniae beween hese cases. On he oher hand, marke response would be idenical in boh scenarios on he day of he announcemen because in boh cases, marke paricipans would no respond o he informaion released in he saemens. Therefore, even hough our mehodology is subjec o limiaions, hese problems do no lead o any economeric problems. 17

21 Surprises in he saemens may arise due o various reasons such as disagreemen beween he CBT and he marke s views on he inflaion oulook, unexpeced changes in he CBT s objecives, marke s misinerpreaion of CBT s signals and so on. In his paper we do no disinguish beween hese cases. We raher ake an agnosic view and idenify saemen surprises direcly from he marke commenaries. Based on his informaion, we are also able o ask he following quesion: Do he marke players updae heir expecaions when hey are faced wih a saemen surprise? If he answer is a yes, his means he moneary auhoriy has some leverage o shape up he yield curve owards is inended direcion. If he answer is a no, ha would sugges he marke largely ignores he signals given by he CBT. Therefore, in our seup, by assessing he significance of he impac of saemen surprises on financial markes, we also implicily es he degree of cenral bank credibiliy. Table A2 in he appendix illusraes he consrucion of ( Surp ST ) wih a few examples based on marke commenaries. The sixh column in Table 1 shows he values of he Surp ST variable for he full sample Empirical Analysis This secion evaluaes he differen aspecs of moneary policy communicaion on financial markes. In he firs par, we invesigae wheher he CBT s signal regarding he nex ineres rae decision ( D ) has improved he predicabiliy of CBT. In he second par, we assess he effecs of cenral bank communicaion over he yield curve. 12 Noice ha his variable is only available afer 2005 because marke commenaries were no available on a regular basis before ha dae. 18

22 4.1. Changes in he Predicabiliy of Cenral Bank Successful communicaion by he cenral bank is expeced o improve he predicabiliy of he cenral bank s acions in he near fuure. One way o es his is o check wheher he signal ha is released by he cenral bank regarding he fuure policy move ( D ) is helpful in predicing he size of he nex policy move. 13 Table 1 provides a quick look a he daa. The firs column in his able shows he policy rae while he second column racks hose insances when he policy rae was changed. The hird and he fourh columns show D and D 1 respecively. 14 Successful signaling by he CBT implies non-zero values in column 2 o be associaed wih non-zero values in column 4, and zeros in column 2 o be associaed wih zeros in column 4. In able 1, hose insances of accurae signaling are shaded. Noe ha he frequency of he shaded rows increase subsanially over ime. Indeed, in he period before 2005, here were 15 cases (whie rows in Table 1) in which he policy acion was no consisen wih he signal released in he previous monh. This is a whopping 43 percen of he observaions for ha period. Meanwhile, here are only six incidences, or 9 13 A his poin we should remind he reader ha he variable D is prepared by consuling wih he officials a he CBT. Hence, i is consruced so as o capure he rue inenions of he cenral bank. Insead, if D were prepared by a compuer or a neural hird pary, we would be esing wheher an ousider s inerpreaion of he nex policy move is helpful in predicing he nex move of he cenral bank (raher han he acual message sen by he cenral bank), which would be a differen quesion o answer. 14 Table 1 is consruced a he monhly frequency. In he period before 2005, MPC meeing schedules were no public knowledge and only policy rae changes were announced publicly. In hose monhs when here were no policy announcemens, D is se equal o zero. 19

23 percen of observaions, in which he policy change was inconsisen wih he previous signal in he period afer While a close correspondence beween D 1 and he curren policy acion poins o successful communicaion by he cenral bank, he reverse is no necessarily rue. This is because lack of a correspondence beween D 1 and he curren policy acion may arise from a quick reversal of marke developmens ha force he cenral bank o change is inenions since he las policy meeing. The policy easing ha came in response o he financial urmoil in Sepember 2007 is a good example of his siuaion. During is policy meeing in Augus 2007, he CBT signaled ha policy raes would say consan in Sepember, and hence D was se equal o zero in ha monh. The oubreak of he crisis in he US morgage marke in Augus 2007 led he CBT o updae he exernal oulook on he downside and iniiae an earlier-han expeced easing cycle in Sepember Wheher he signals provided by he CBT improves he predicabiliy of he policy decisions can be esed formally by measuring he informaive capaciy of D 1 in predicing he CBT s nex policy decision. The forecasing model developed by Hamilon and Jorda (2002), he Auoregressive Condiional Hazard (ACH) model, is a very suiable ool for his purpose. In he nex sub-secion we briefly describe he ACH model. Readers who are familiar wih (or no ineresed in) he echnical aspecs of his model can move on o he following sub-secion where we inerpre our resuls derived from he ACH model. 20

24 The Auoregressive Condiional Hazard Model The ime series of policy rae changes has unusual saisical properies and are ypically referred o as a marked poin processes in he saisics lieraure. One of hese properies is ha he policy rae is changed irregularly in ime. Tha is, we are uncerain abou when he policy rae will be changed nex, given informaion available oday. The process describing when evens ake place in ime is called a poin process. The value ha he poin process akes a each even ime is called he mark. For he purposes of his paper, we are only ineresed in he poins and no he marks. This is because he variable, D wihou is size., only provides informaion abou he direcion of he nex policy move In paricular, le x = 0 if here is no change in he policy rae afer he policy meeing in monh, and x = 1 if here is a change hus, x describes he process for he poins (Column 2 in Table 1). Le z denoe a vecor of exogenous variables ha capure he informaion ha were released a he las policy meeing, which is exercise. Le D 1 in our Ω denoe he informaion se in monh. Our ask is o model he probabiliy disribuion of x condiional on he pas. The ACH model seeks an answer o he following quesion: Wha is he probabiliy ha during he nex policy meeing, he policy rae will be changed, condiional on informaion available oday? Denoe his probabiliy by h, ypically referred o as he hazard in he duraion lieraure. Then, h = P( x = 1 Ω 1). In addiion, we define he following auxiliary variables. Le { ω 1 }, = 1,2,..., T be a 21

25 sequence ha, for any dae records he dae of he mos recen change in he policy rae as of ime, ω = x + (1 x) for = 1,2,..., T 1 ω1, 1 so ha ω 1 = if he policy rae changes on monh and ω1τ says a for subsequen monhsτ unil a new rae change. In general, le ω j be he dae of he policy rae change as of dae : ω for j = 2, 3,... and = 1, 2,..., T j = xω j 1, 1 + ( 1 x ) ω j, 1 h j mos recen Using his noaion, ω1, 1 ω2, 1 corresponds o he lengh of he duraion beween he mos recen wo policy rae changes as of dae 1 (Column 5 in Table 1). In general, he duraion beween he j h and he ( j + 1) h mos recen policy rae changes is u = ω ω. j, 1 j, 1 j+ 1, 1 Going back o he hazard rae, noe ha if he only informaion conained in Ω 1 were he daes of previous policy rae changes, he hazard rae h would no change unil he nex policy rae change. Le ψ denoe he expeced lengh of ime unil he nex change, hen 1 ψ = = (1) h 1 (1 ) j j h h j= 1 I is naural o generalize expression (1) by allowing ψ o have a radiional linear ime series represenaion for he condiional firs momen and o incorporae he effecs of exogenous variables, linearly. In an expression similar o ha adoped in Hamilon and Jordá (2002), 22

26 1 h = ( ψ + δ ' z 1) ψ = ω + θ u + βψω j= 1 j j, 1 j= 1 j j, 1 (2) where he denominaor is appropriaely consrained o ensure ha i is posiive and h [0,1]. The likelihood associaed wih expression (2) is simply log 1 log 1 (3) which can be maximized numerically wih respec o he vecor of populaion parameers by sandard procedures. The Esimaion Resuls from he ACH Model The ACH model is esimaed for our sample period ha spans from February 2002 hrough July Table 2 repors he maximum likelihood esimaes of he final ACH model for he full sample (column 1) as well as he period before 2005 (column 2). The esimaes sugges somewha persisen serial correlaion in he hazard for he pre sample, wihθ + β = 0.34, which disappears for he full sample, wihθ + β =0.13. Our primary goal in esimaing he ACH model is o check he predicive abiliy of he communicaion variable, D 1. In order o es wheher here is any asymmery beween he easing and he ighening signals, we decompose his variable ino D 1 (Posiive), D 1 (Negaive), and D 1 (Neural). Accordingly, D 1 (Posiive) reflecs 15 We exclude June 2006 from he analysis. During his monh here were wo inermeeing changes one before and one afer he regularly scheduled policy meeing. 23

27 he value of D 1 when i is posiive. Tha is, his variable capures hose insances when he CBT signaled a ighening for he nex monh, and is 0 oherwise. The negaive and significan coefficien associaed wih his variable indicaes ha he probabiliy of a policy change rises significanly when he CBT sends a sronger ighening signal, an expeced resul. 16 The variable D 1 (Negaive) racks he values of D 1 when he CBT sends an easing signal. Hence, he values of his variable range beween -2, -1, and 0, wih -2 reflecing he sronges easing signal and 0 reflecing a neural signal. The coefficien associaed wih D 1 (Negaive) is posiive and significan. Increases in his variable, which indicae weaker signals owards an easing and sronger signals owards no change, decrease he probabiliy of an ineres rae change. In fac, he coefficien esimaes associaed wih D 1 (Posiive) and D 1 (Negaive) are almos he mirror images of each oher and he difference beween hem is no saisically significan. This resul suggess ha here is no asymmery regarding he signals sen before policy easings or ighenings. Finally, he indicaor variable D 1 (Neural) akes he value of 1 when he CBT sends a neural signal (i.e. D 1 =0) and 0 oherwise. The posiive and significan coefficien associaed wih his variable indicaes ha a neural signal decreases he chances of a rae change, consisen wih he naure of he message. These resuls are very inuiive and sugges ha he CBT sends he righ messages o prepare he markes abou is nex policy acion. Meanwhile, he second column shows he esimaes 16 Recall from equaion (2) ha he vecor of explanaory variables, z,, is inversely relaed o he hazard rae. Hence, a negaive coefficien esimae in Table 2 indicaes ha he paricular variable in quesion lowers he denominaor and hence increases he hazard rae. 24

28 of he model for he period before None of he componens of D 1 are significan for his sample. 17 This is consisen wih he insiuional seup of moneary policy during he pos-2005 period, where he CBT made no explici effor o signal is nex ineres rae move hrough policy saemens (see secion 2.1). In addiion o model fi, we also explored he model s forecasing performance. The ACH produces forecass of he probabiliy ha, condiional on informaion signaled by D 1, he CBT will change he policy rae in he nex monh. We ermed his probabiliy as he hazard and we denoe is forecas by h ^. On he basis of his probabiliy forecas, one can consruc he series of prediced changes, x ^ by comparing h ^ o he average hazard over he period, h as follows, ^ x 0 if ^ h < h = ^ 1 if h h The saisics lieraure provides wo convenional measures o gauge he model s performance: specificiy and sensiiviy. Specificiy measures he proporion of evens (i.e. x = 1) ha were properly forecased ( x ^ = proporion of non-evens ( x = 0 1) while sensiiviy measures he ) properly forecased ( x ^ = 0 ). As an illusraion, had we chosen he forecas: x ^ = 1 for all, our specificiy measure would have scored a perfec 100% while our sensiiviy measure would have scored a disasrous 0%. The 17 Noe ha here are no ighening signals (or a rae hike) in he period before 2005 and hence (Posiive) is dropped from ha sample. D 1 25

29 values aained by he ACH models are quie well balanced and srikingly high for he full sample (76% and 83% respecively). The predicive power of he model is subsanially lower for he pre-2005 sample wih he specificiy and he sensiiviy measures of 42% and 50% respecively. These resuls are highly consisen wih he discussion in secion 2.1 ha prior o 2005 he iming of he policy decisions was no predicable and he saemens did no provide sysemaic informaion on he fuure course of moneary policy. Meanwhile, wih he significan seps aken owards ransparency afer 2005, he CBT now provides a subsanial amoun of informaion regarding is nex policy move The Yield Curve Response o Moneary Policy Surprises So far, we have shown ha he CBT pursues a successful communicaion policy hrough is wrien saemens in preparing he markes for is nex policy decision. In oher words, he CBT guides he markes in he righ direcion. In his secion, we go one sep furher and ry o assess he impac of moneary policy on he erm srucure of ineres raes. Since financial markes respond only o unanicipaed informaion released in policy saemens, we measure he response of he yield curve o moneary policy surprises. Moneary policy surprises can ake place eiher by acions or words. Therefore, we firs evaluae he impac of he surprises in ineres rae decisions (acions); nex, we move o he main heme of he paper and evaluae he effecs of he surprises in policy communicaion (words). 26

30 Surprises in Ineres Rae Decisions Following Kuner (2001), he responsiveness of financial markes o policy rae changes is ypically esed hrough equaion (4) where he change in he erm rae is regressed on he expeced and surprise componens of a policy change: α β 1 β (4) r = + Exp PR + 2Surp PR where r is he change in he erm rae, Exp PR and Surp PR are he expeced and surprise componens of he change in he policy rae. In his paper, we calculae he anicipaed and he unanicipaed componens of he policy rae based on (i) surveys or (ii) marke based measures. The marke based measure of he unanicipaed policy change is calculaed as he daily change in one-monh consan mauriy series following Rigobon and Sack (2004). Because of he shor mauriy of he underlying securiy, we do no expec he surprise componen o reflec any informaion regarding he unanicipaed componen of he policy saemen (which covers a longer ime span). For robusness purposes, Equaion (4) is calculaed using he expeced and surprise series ha are derived via boh mehodologies. We esimae equaion (4) for six-monh, one-year, wo-year, and hree-year governmen bond raes as well as he benchmark ineres rae. 18 Tables 3a and 4a show he esimaion resuls using survey based and marke based measures of expecaions respecively. The resuls indicae ha Turkish financial markes ac consisenly wih he expecaions hypohesis, as also shown by Akaş e al. (2008) and Demiralp and Yılmaz (2010). Following a policy acion, marke paricipans only respond o he unanicipaed 18 Benchmark ineres rae is he ineres rae of he mos liquid governmen securiy in Turkey (ypically wih mauriy beween one and wo years). 27

31 porion of he policy change. Overall, he esimaes obained from he wo measures are prey close o each oher and close o hose obained for he US by Kuner (2001). Unlike he US case, however, here is no a significan decline in he response coefficiens when he mauriy of he securiy lenghens. Specifically, in response o a percenage poin surprise change in he policy rae, he yield curve shifs abou 50 basis poins. Surprises in Communicaion The specificaion in equaion (4) implicily assumes ha he only driving force behind ineres rae movemens following a policy acion is unanicipaed ineres rae changes. I overlooks any poenial response o unanicipaed changes in policy saemens. Meanwhile, i is no very difficul o hink of examples where he marke response was driven solely by surprise saemens raher han he decision iself. In our sample, we have several such cases: Figure 2 shows he changes in he yield curve on he days afer he MPC meeing in April 2007, July 2007, April 2008, and Sepember Wha is common for all hese daes is ha here was no ineres rae change and his was perfecly anicipaed by marke paricipans. Neverheless, he CBT changed he moneary policy sance by changing he wording in all four cases, which ook marke paricipans by surprise. In April 2007 and April 2008, he CBT adoped a igher policy sance han expeced. As a resul, he yield curve shifed up on hese days. In July 2007 and Sepember 2008, his ime he CBT changed he wording of he saemen by implying an easier sance han expeced which led o a downward shif of he yield curve. These examples illusrae ha even if here is no ineres rae surprise, unanicipaed 28

32 changes in policy saemens are very relevan in explaining changes in he yield curve. The res of his secion seeks o verify his observaion hrough empirical analysis. To his end, we augmen equaion (4) wih saemen surprises and esimae he following equaion: 19 r = + β1exp PR + β2surp PR + β3 α Surp ST (5) where Surp ST refers o he surprise changes in policy communicaion as described in secion 3.3. To he exen ha he informaion conained in ineres rae changes are relaed o changes in policy saemens, equaion (5) provides a more comprehensive version of equaion (4) and addresses any poenial bias due o omied variables. If, on he oher hand he informaion conained in ineres rae changes are orhogonal o he forward looking informaion refleced in he saemens, hen ess of he sensiiviy of he yield curve o moneary policy announcemens via equaion (4) following Kuner (2001) should produce valid coefficien esimaes even hough equaion (5) is a more comprehensive specificaion. 20 Tables 3b and 4b show he esimaion resuls from equaion (5). Noe ha he marke response o policy saemens is in line wih expecaions and highly significan for he unanicipaed changes. We observe ha he yield curve shifs by up o an addiional 20 basis poins due o surprise changes in policy saemens (row five). The explanaory power of he regression increases significanly by five o en percenage 19 The sample period sars in 2005 because marke commenaries of policy saemens are only available afer his dae. 20 The simple correlaion coefficien beween CBT Surp PR and Surp ST coefficien beween Marke Surp PR and Surp ST is is 0.45 while he simple correlaion 29

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