Words Speak as Loudly as Actions: Central Bank Communication and the Response of Equity Prices to Macroeconomic Announcements

Abstract

We study the impact that macroeconomic news has on equity prices. While the literature has already widely documented the effects of macroeconomic announcements on asset prices, as well as their asymmetric impact during good and bad times, we focus on the reaction to news when the description of the state of the economy---as painted by the Federal Open Market Committee (FOMC) statements---deteriorates. We develop a novel FOMC sentiment index using textual analysis techniques, and find that news has a bigger impact on equity prices during bad times as described by our FOMC sentiment index. This finding is consistent with previous literature, which finds that the stock market's reaction depends on the state of the economy, except that the FOMC's description of the state of the economy is the variable that best explains the variation in the response---more so than the state of the economy itself as measured by real-time indices. Our interpretation is that the reaction of equity prices to news depends on the probability of an increase in interest rates, and the FOMC's description of the state of the economy is one of the best predictors of this probability.

Keywords: Monetary policy, public information, probability of a recession, price discovery, FOMC, sentiment, textual analysis

JEL Classification: C53, D83, E27, E37, E44, E47, E5, G1