Central bankers' words predict a slowly easing monetary policy

Oh brother, I can't believe it's true

I'm so scared about the future, and I wanna talk to you

Oh, I wanna talk to you

Coldplay in the song Talk

As policy rate hikes have ended and monetary policy has moved to the wait-and-see side, central bank communication is playing an increasingly important role. From what we've heard, it seems that easing is on its way.

Central banks as mouthpieces

Central bank communication plays an important role, in particular in creating trust and credibility between the public and the central bank. When the public (e.g. investors) knows what a central bank is doing, it also facilitates the conveyance of monetary policy. Communication now plays an important role in the effectiveness of monetary policy: It can signal the direction of future monetary policy, adjust expectations and, thus, reduce uncertainty on the financial markets.

Central banks no longer sit in their foxholes as they did in the past but have tried in every way to increase the transparency of their monetary policy. This has also increased the amount of communication, and today, the words and views of central banks can be read almost daily on international news agencies' websites. At the same time, communication has become clearer. As shown below in graphs by Miika Purola, there has been clear progress in the speeches of ECB Presidents over the years, measured by Flesch-Kincaid scores. Scores measure how many years of training is needed to understand the text read based on the length of sentences and words. In other words, the lower the score, the better the readability.

Source: Inderes, ECB

Source: Inderes, ECB

The clarity of communication helps to improve transparency, so steps in the right direction have also been taken in this respect. However, the pursuit of transparency can go too far, as the range of speeches and opinions may turn into cacophony, which ultimately weakens, for example, investors’ ability to form expectations about the future direction of monetary policy (topic discussed here).

Communication as a crystal ball

From the investor's viewpoint, central bank communication is genuinely worth paying attention to, as it anticipates the direction of monetary policy. Typically, central banks have become hawkish before the policy rate rises and dovish before monetary policy is eased. Bloomberg found an excellent tool for analyzing speeches, namely the hawk-dove score compiled by JPMorgan. In it, the speeches of the ECB's Governing Council, the speeches of the management of the Riksbank and the views of the Fed's Securities and Exchange Commission are squeezed into indices, where positive figures indicate hawkish speeches and negative ones dovish speeches. As you can see from the graphs, the hawkishness of central banks has already reached its peak, and the tone of the speeches has become slightly lighter. We are not in a dovish mood yet, but we are heading toward it. The Riksbank’s speech score (collected from published speeches of central bankers) is highly volatile, so it is not quite as good an indicator as for the ECB and the Fed.

As the longer time series show, central banks’ speeches often turn dovish only when the policy rates start to fall. Conversely, speeches turning hawkish has been a better predictor of future monetary policy as can be seen in the two previous rate hike cycles. Central bankers are, therefore, somewhat prone to hawkishness in their words, which must also be considered by investors waiting for rate hikes.