Optimistic language used by the Federal Reserve (Fed) in their communication can reduce market uncertainty and risk aversion in the US, UK and Eurozone equity markets, according to new research from the Department of Finance.
The study also found that the Fed’s language became even more influential during recessions and times of high policy uncertainty, such as elections. The research, conducted by Associate Professors of Finance, Frankie Chau and Rataporn Deesomsak, alongside Raja Shaikh, from Sukkur IBA University, Pakistan, sought to understand the impact of Fed’s communication and language when it came to equity markets.
The researchers used a linguistic tool to analyse the tone and sentiment in Federal Open Market Committee (FOMC) meeting minutes, which are widely reported in the media. To gauge market volatility and risk aversion, the researchers employed an option-implied volatility index on the S&P500 index (VIX), FTSE-100 index (VFTSE), and STOXX-50 index (VSTOXX). In doing so, they were able to link the tone of communication in the Fed’s meeting minutes with changes in volatility of the equity market in the US, UK and Eurozone.
The study revealed that positive and optimistic communication in the Fed’s meeting notes led to much less volatility in the market. More specifically, uncertainty decreases by 0.42 percentage points in response to one percentage point increase in the Fed's optimistic tone. In addition, one percentage point increase in Fed's optimistic tone also decreases the investor's risk aversion (increases the risk-bearing capacity) by 0.38 percentage points.
According to researchers, these findings underscore the Fed’s authority and influence in shaping market sentiment, even with subtle shifts in tone.
The impact of Fed communication was found to be particularly pronounced during times of greater market uncertainty—such as elections, recessions, or market downturns—when the Fed’s guidance becomes even more critical for investors.
"With the US election round the corner, the US’ future monetary policy is uncertain, and the stock market will act as a key barometer of confidence in the next incoming leader.”, says Dr Chau. “The transition of power brings uncertainty and volatility to the markets, and our research clearly shows that the Federal Reserve’s steady, independent voice is more crucial than ever in maintaining economic stability and guiding investors through unpredictable times."
These findings, Dr Chau states, highlight the importance of the Central Bank’s communication when it comes to affecting the market, and policy makers must carefully design a transparent communication strategy to ensure market stabilisation and effective implementation of monetary policy.
With this in mind institutions such as the Central Bank, they stress, should always be mindful of using pessimistic language as financial markets tend to overreact to negative news, especially during recessions and economic downturns.
Whilst for investors, these findings showcase just how impactful the Fed can be when it comes to shaping and impacting the market – their authoritative voice is clearly trustworthy and should not be ignored.
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