Forecasting the direction of policy rate changes: The importance of ECB words.

This paper evaluates the predictive power of di?erent information sets for the European Central Bank (ECB) interest rate setting behavior. We employ an ordered probit model, i.e. a limited dependent variable framework, to take into account the discreteness displayed by policy rate changes. The results show that the forecasting ability of standard Taylor-type variables, such as in?ation and output gap, is fairly low both in-sample and out-of-sample, and is comparable to the performance of the random walk model. Instead by using broader information sets that include measures of core in?ation, exchange rates and monetary aggregates, the accuracy of the forecasts about ECB future actions substantially improves. Moreover, ECB rhetoric contributes to a better understanding of its policy reaction function, and ECB statements complement the information contained in actual macro ?gures. Finally, we ?nd that that the ECB has been fairly successful in educating the public to anticipate the overall future direction of its monetary policy, but has been less successful in signaling the exact timing of rate changes.