Do financial markets react to Bank of England communication?

Abstract

This paper examines how United Kingdom financial markets react to Bank of England communication. We might expect asset prices to react to official communication if it is informative to market participants about the policy inclination or economic outlook and risks. We find evidence that the publication of the Minutes of Monetary Policy Committee meetings and the Inflation Report significantly affect near-term interest rate expectations, an effect particularly visible in intraday data. Our results for the United Kingdom are arguably less strong than Kohn and Sack's [Kohn, D., Sack, B., 2003. Central bank talk: does it matter and why? Federal Reserve Board Finance and Economics Discussion Series 2003–55] findings for United States Federal Reserve communication, where the impact extends along the yield curve. Although differences in institutional frameworks between the United Kingdom and United States mean communications are not directly comparable, our results might also reflect the different mandates of the FOMC and the MPC, with the Federal Reserve having greater freedom to interpret its objectives.

Introduction

Since the introduction of inflation targeting in the United Kingdom in 1992, the conduct of monetary policymaking at the Bank of England has become increasingly accountable and transparent. As put by Lambert (2004), the dual response to the ejection of sterling from the Exchange Rate Mechanism was:

‘…a shift to inflation targeting as a way of imposing discipline on monetary policy and to greater transparency in an effort to build badly-needed credibility.’

This reflects, and is consistent with, a broader shift to transparency in monetary policymaking by central banks internationally (discussed, for example, in Chortareas et al., 2002), a strategy stemming from a view that openness and communication can play a role in enhancing the credibility of a central bank's actions, so helping to maintain low inflation and a stable macroeconomic environment. As a result, clarity and congruency of communication becomes more important.

Effective communication can help anchor expectations and assist in achieving the central bank's objectives. Formally, in the theoretical literature, Eggertsson and Woodford (2003) stress the crucial role of expectations in the making of monetary policy. Although policymakers only have direct control of the short term policy rate, they want to shape interest rate expectations along the yield curve, as noted by Bernanke (2004):

‘Control of the federal funds rate is (therefore) useful only to the extent that it can be used as a lever to influence more important asset prices and yields–stock prices, government and corporate bond yields, mortgage rates–which in turn allow the Fed to affect the overall course of the economy.’

Previous work undertaken at the Bank of England has studied whether the move to inflation targeting in the United Kingdom has affected financial markets’ reaction to Bank of England policy announcements and macroeconomic data releases.¹ In this paper, we investigate the extent to which financial markets respond to the different forms of official communication issued by the Bank of England since its operational independence in 1997, testing for the impact of communication on the variance of interest rate expectations implicit in fixed income markets, on equity prices and the exchange rate, using selected daily and intraday data.

The key forms of communication from the Bank of England's MPC are the Minutes of the meetings of the MPC, the quarterly Inflation Report, regular speeches given by the Governor and other committee members and evidence given to parliamentary committees. Our key hypothesis is that volatility increases following official communication — as markets react to its content.

Consistent with the methodology of Kohn and Sack (2003), we look at the variance (rather than the mean) of financial asset prices because it is difficult to quantify, or even determine the direction, of a communication ‘surprise’. Using daily data, we find evidence that Bank of England communication, specifically the MPC Minutes, increases the sample variance of implied interest rates from short-maturity short sterling futures contracts. Using intraday data, where we can better isolate the effect of communication, we get stronger results, with a significant response to the publication of MPC Minutes and the Inflation Report. This adds weight to the hypothesis that financial markets react to Bank of England communication.

Our results are somewhat less pronounced than those documented for the United States. Kohn and Sack (2003) find that FOMC communication–in the form of written policy statements and testimony to Congress by Chairman Greenspan–significantly affects interest rate expectations along the yield curve using daily data. This might suggest that FOMC communication matters more for United States financial markets than Bank of England communication matters for United Kingdom financial markets. As well as differences in institutional frameworks our results might reflect the Bank of England's explicit inflation target and the seemingly more dominant role of the FOMC Chairman compared with the Bank of England Governor.

The remainder of the paper is structured as follows. Section 2 describes the framework for monetary policy in the United Kingdom and the relationship between transparency and the conduct of policy. Section 3 reviews the literature on communication and financial markets. Section 4 details the forms of Bank of England communication we consider. 5 Methodology, 6 Data and pre-processing explain our methodology and the data we use, and Section 7 sets out our results, including an analysis of possible explanations for the different results in the literature. Section 8 offers some conclusions.