Reading between the lines - Using text analysis to estimate the loss function of the ECB
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The document explores the estimation of the European Central Bank's (ECB) loss function using text analysis and text mining techniques applied to communication from the ECB's governing council. It reveals that the ECB appears to have an 'asymmetrical' preference regarding inflation targets, suggesting that actual inflation aims may be considerably lower than the official target of 2%. The analysis indicates a relationship between qualitative communication and the economic outlook, highlighting significant implications for monetary policy strategies.
![Extension with Linex (linear exponential) loss function
Piecewise linear loss function does not allow any convexity in the
preferences, so we consider also Linex loss function such that
Nt = α + γ
exp [θ (πt − π∗)] − θ (πt − π∗) − 1
θ2
+ εt (8)
Larger the parameter j, more averse the CB is for inflation rates
above the target (asymmetry is captured by one single parameter)
When parameter θ approaches zero, loss function becomes quadratic
(and symmetric) around some target π∗.
Kilponen Reading between the lines 24 November 2020 10 / 19](https://image.slidesharecdn.com/20201124-bank-of-finland-juha-kilponen-reading-between-the-lines-201124134022/85/Reading-between-the-lines-Using-text-analysis-to-estimate-the-loss-function-of-the-ECB-10-320.jpg)
Reading between the lines - Using text analysis to estimate the loss function of the ECB
- 1. Reading between the lines - Using text analysis to estimate the loss function of the ECB Maritta Paloviita, Markus Haavio, Pirkka Jalasjoki, Juha Kilponen and Ilona Vänni Juha Kilponen 24 November 2020 Bank of Finland Webinar: New Challenges to Monetary Policy Strategies The views expressed do not necessarily reflect the views of the Bank of Finland or the Eurosystem Kilponen Reading between the lines 24 November 2020 1 / 19
- 2. Introduction Usual way to assess policy objectives of the central bank is to estimate a linear reduced form reaction function (e.g. Taylor type rule) such as it = ρit−1 + (1 − ρ)(α + βπ(πf t+j|t − π∗ ) + βy ∆yf t+k|t + Drn t ) (1) Left hand side: policy instrument Right hand side: deviation of inflation (forecast) from the target, some measure of cyclical position of the economy, real natural rate Parameters: Convolutions of CB preferences and structural parameters of the economy, so it is not possible to infer directly what the CB preferences are Kilponen Reading between the lines 24 November 2020 2 / 19
- 3. Introduction ECB price stability In 1998, the GC defined price stability as a ’year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%’. In 2003, the GC clarified that ‘in the pursuit of price stability it aims to maintain inflation rates below, but close to, 2% over the medium term’. Kilponen Reading between the lines 24 November 2020 3 / 19
- 4. Related literature Assessing “de facto” target and asymmetries by reaction function based approach Hartmann and Smets (2018), Rostagno et al. (2019), Paloviita et al. IJCB forthcoming De facto inflation target is well below 2 % ECB has reacted to deviations of inflation from 2% in asymmetric way Analysis of monetary policy communication using text mining techniques Shapiro and Wilson (2019), Baranowski et al. (2020), Picault and Renault (2017), Berger et al. (2011), Ehrmann and Talmi (2020), Hansen and McMahon’s (2016), Armelius et al. (2020), Kawamura et al. (2019), Jones et al. IJF forthcoming, Kawamura et al. (2019), Bennani et al. (2020), Fraccaroli et al. (2020) Evaluation of real time data and central bank forecasting Fujiwara (2005), Hubert (2014, 2015, 2017), Lyziak and Paloviita (2017, 2018), Potter (2011), Stockton (2012), Fawcett et al. (2015), Iversen et al. (2016), Kontogeorgos and Lambrias (2019) Kilponen Reading between the lines 24 November 2020 4 / 19
- 5. Reading between the lines What does qualitative communication reveal about the ECB GC’s preferences? Apply text mining techniques (language processing) to introductory statements in order to infer the ECB GC’s objectives directly Construct net negativity index (tone) which measures the sentiment (positive, negative) in the introductory statements We relate this proxy for the loss to real time economic outlook for inflation and output in order to estimate the loss function Approach is similar to Shapiro and Wilson (2019) who study Fed Kilponen Reading between the lines 24 November 2020 5 / 19
- 6. Net negativity index (tone) Pre-process the text using standard steps in the text analysis Use Loughran & McDonald (2011) finance-specific dictionary to classify words into three classes (negative, positive and neutral) based on their sentiment. We modify dictionary to add some central bank specific terms and expressions Net negativity index: The difference of the number of negative and positive words, normalized with the total number of words in the ECB introductory statement: Nt = #Neg − #Pos #Tot (2) Let us look how the tone have evolved in 1999-2019. . .Kilponen Reading between the lines 24 November 2020 6 / 19
- 7. Tone (net negativity) Decreasing trend before the financial crisis After the peak in the middle of the financial crisis, a gradual fall (increasingly more positive) until the end of 2017 Pessimistic tone in 2019 Kilponen Reading between the lines 24 November 2020 7 / 19
- 8. Constructing loss function Assume that CB’s loss is a function of deviation of inflation from the target such that Lt = |π − π∗ | (3) and that we can relate the net negativity index (N) to this loss such that N = α + δL (4) Then we can attempt to estimate a loss function such that Nt = α + δ |πt − π∗ | + t (5) d parameter is the preference parameter we are interested in. We can also treat π∗ as latent variable and estimate it. Kilponen Reading between the lines 24 November 2020 8 / 19
- 9. Extension to analyse asymmetry and other objectives Split the right hand side into two separate segments (piecewise linear loss function) Nt = α + δB ˜π− t (1 − D) + δA ˜π+ t D + εt (6) add the output gap terms Nt = α + δB ˜π− t (1 − D) + δA ˜π+ t D + β1∆ ˜yt + β2∆ ˜yt 2 + εt (7) . . . and we can estimate (and test) directly the degree of asymmetry in the CB’s preferences. Kilponen Reading between the lines 24 November 2020 9 / 19
- 10. Extension with Linex (linear exponential) loss function Piecewise linear loss function does not allow any convexity in the preferences, so we consider also Linex loss function such that Nt = α + γ exp [θ (πt − π∗)] − θ (πt − π∗) − 1 θ2 + εt (8) Larger the parameter j, more averse the CB is for inflation rates above the target (asymmetry is captured by one single parameter) When parameter θ approaches zero, loss function becomes quadratic (and symmetric) around some target π∗. Kilponen Reading between the lines 24 November 2020 10 / 19
- 11. Right hand side variables We use short run real time Eurosystem/ECB staff macroeconomic projections for inflation and output gap (BMPE/MPE) The average of the inflation nowcast and one-quarter-ahead projected inflation rate The average of the output gap nowcast and one-quarter-ahead projected output gap Note: The right hand side variables are similar to what are used in the reaction function estimations. Kilponen Reading between the lines 24 November 2020 11 / 19
- 12. Overview of the Results The ECB has been either more averse to inflation above 2% or “de facto” inflation aim has been considerably below 2% Results are robust to the tone measure (general/inflation specific) the functional form of the loss function (piecewise linear/Linex) inclusion/exclusion of output gap terms to the loss function Kilponen Reading between the lines 24 November 2020 12 / 19
- 13. Estimated Piecewise-Linear loss function Kilponen Reading between the lines 24 November 2020 13 / 19
- 14. Estimated Piecewise-Linear loss function Kilponen Reading between the lines 24 November 2020 14 / 19
- 15. Estimated Piecewise-Linear loss function Kilponen Reading between the lines 24 November 2020 15 / 19
- 16. Estimated Piecewise-Linear loss function Kilponen Reading between the lines 24 November 2020 16 / 19
- 17. Estimated Linex loss function Kilponen Reading between the lines 24 November 2020 17 / 19
- 18. Estimated Linex loss function Kilponen Reading between the lines 24 November 2020 18 / 19
- 19. Conclusions Analysis confirms the earlier findings based on reaction function estimations Somewhat stronger evidence in favor of asymmetry Low de facto target and asymmetry: Stabilizing during the period of high inflationary pressures Possibly costly when inflationary pressures have been low Lowered inflation expectations Increased probability to hit the effective interest rate lower bound Reduced monetary policy space Kilponen Reading between the lines 24 November 2020 19 / 19