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Eurozone Insight

Tue, Aug 5 2008, 14:31 GMT
by Yapi Kredi Bank Economic Research Department

Yapi Kredi Bank

• ● The last two ECB meetings have resulted in the largest bond sell-off (June 5) and the largest bond rally (July 3) ever occurred on the day of a regular Governing Council meeting.

• ● This has brought the issue of communication back to the fore, ending the two-year long honeymoon between the ECB and the markets and bringing back visions of the bad old times when a disconnect between the central bank and market players seemed to be the rule. 

• ● The analysis developed in this paper casts some interesting light on central bank communication and on its nature, purpose, and pitfalls. The main conclusion of the analysis in our view are as follows: 

• ● Central bank communication is an ongoing effort to gradually educate market participants on how the bank processes and reacts to macroeconomic data: communication gradually reveals the core of the policy reaction function. For the ECB we have shown that this is indeed the case. 

• ● Data, and not words will be the main market movers in normal times. However, communication is crucial when there is a change in the policy reaction function. This in our view is exactly what happened in June. The abrupt market reaction indicates that the change in regime had not been communicated effectively, and points in our view to a weakness in the ECB’s communication framework. In case of a regime switch or a sudden change in the assessment of the economic outlook, intermeeting communication can play a precious role. 

• ● Our analysis shows that ECB communication has been very effective in securing long-term predictability, whereas short-term predictability has broken down in recent months. This, however, might have partly been seen as the price to pay to enhance long-term predictability and antiinflation credibility. In other words, the June surprise might have been not just a communication dysfunction, but rather a conscious decision to shock the markets, to impress upon investors the seriousness of the ECB’s anti-inflation resolve.

• Download full report with charts

Published on  Tue, Aug 5 2008, 14:40 GMT