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

This paper evaluates the predictive power of different information sets for the European Central Bank(ECB) interest rate setting behavior. We employ an ordered probit model, i.e. a limited dependent variableframework, to take into account the discreteness displayed by policy rate changes. The results show that theforecasting ability of standard Taylor-type variables, such as inflation and output gap, is fairly low both insampleand out-of-sample, and is comparable to the performance of the random walk model. Instead byusing broader information sets that include measures of core inflation, exchange rates and monetaryaggregates, the accuracy of the forecasts about ECB future actions substantially improves. Moreover, ECBrhetoric contributes to a better understanding of its policy reaction function, and ECB statementscomplement the information contained in actual macro figures. Finally, we find that that the ECB has beenfairly successful in educating the public to anticipate the overall future direction of its monetary policy, buthas been less successful in signaling the exact timing of rate changes....