This paper proposes that an important instrument of monetary policy of the Bundesbank is how it communicates with the public. We argue that communication by senior central bank officials represents an instrument of monetary policy that complements changes in interest rates. Moreover, the communications instrument can partly explain how a central bank can respond to real economic developments even as it focuses on an inflation objective. Using monthly data, we show how speeches by the Bundesbank’s President dealing with inflation help explain both interest rate movements as well as the central bank’s response to the unemployment rate.
Historically, the Bundesbank ranks as one of the most successful central banks. One measure of its success is how the Bundesbank sets interest rates in response to economic shocks, especially of the inflationary variety (e.g., Bernanke and Mihov, 1997, Clarida and Gertler, 1997 and Deutsche Bundesbank, 1999). However, interpreting central bank behavior, including that of the Bundesbank, via a reaction function approach of the Taylor variety, does not tell the whole story. Goodhart (1999), for example, points out that standard reaction functions do not incorporate variables other than economic shocks. He argues that there must be additional factors in the conduct of monetary policy that are not adequately modeled using the standard reaction function approach.
Indeed, the usual interest rate rules do not capture what may be a crucial element that explains the conduct of monetary policy in Germany (and, likely, elsewhere), namely the vital role of public communication by senior central bank officials.1 For example, Goodfriend (1999) emphasizes the communication function of the US Federal Reserve, and traces the use of this instrument as a tool to enhance the credibility of its policies to the Volcker era of the 1980s. We show empirically that public communication is an important element in understanding the conduct of German monetary policy. It can serve to signal monetary policy intentions and influence expectations. By implication, this type of “open mouth operation”, if successful, can also enhance a central bank’s credibility or help maintain its reputation.
Although there is a small but important literature on the subject of how central banks communicate with the public, it is largely theoretical. Our main conclusion is that communication with the public acts as an instrument of monetary policy. We document such a result via the estimation of reaction functions for the Bundesbank that include a variable proxying communication by central bank officials. In demonstrating this result we construct a novel data set.
The paper is organized as follows. The next section briefly describes the conduct of monetary policy at the Bundesbank, and the role of communication with the public and government. Section 3 develops a forward-looking reaction function for the Bundesbank that incorporates a role for public communication. We argue that a separate reaction function for public communication by central bank officials serves to supplement a standard type of reaction function. We also examine, in so far as it is possible, the potential role of using real-time data in this context. Section 4 discusses the data and the choice of instruments used to implement the GMM estimation approach. The empirical evidence is discussed in Section 5. The conclusions summarize our results and its implications for the conduct of monetary policy more generally.
The aim of this study was to empirically demonstrate the role of communication in the making of central bank interest rate policy. The title of the paper asks whether “actions”, that is, interest rate decisions taken by the Bundesbank, can speak louder than communications by Bundesbank senior officials with the public and the government through speeches. The tentative answer seems to be in the affirmative. Nevertheless, there is also evidence that these two instruments of monetary policy complement each other. Communications via frequent speeches, especially on issues dealing with price developments, exchange rates, and economic policy more generally, appear to have been a valid instrument of the Bundesbank, in both economic and statistical terms, that helps explain interest rate behavior in a Taylor rule framework.
This lesson is probably not lost on the monetary authorities in many countries that have made a concerted effort to improve and highlight this function, as well as in steps taken to increase central bank transparency. Indeed, it is now common for central banks to publish with little delay speeches by their senior officials, and to disseminate them as widely as possible. To be sure, “communication” is more general than the substance of speechmaking as it is likely to go hand in hand with accountability and transparency.
Despite our findings additional work remains. While direct interest rate actions can be readily interpreted, even if the exact sources that led to such changes remains somewhat elusive, it is a much more difficult task to measure with more precision the signaling content of speeches. Furthermore, central banks increasingly communicate in a variety of forms and it would be useful to evaluate whether speeches have more or less impact on expectations, for example, than a monetary policy report or a press release. We leave these issues for future research.27
