Do central bank sentiment shocks affect liquidity within the European Monetary Union? A computational linguistics approach

A common feature of recent financial crises has been the ‘drying up’ of financial market liquidity. Increased attention, therefore, has been directed to central bank policy tools which can affect liquidity, even as policy rates approach the zero lower bound. This study examines the role of the European Central Bank (ECB) Governing Council’s communication in influencing financial market liquidity. A specialized lexicon is used to extract sentiments on (i) monetary policy and (ii) economic outlook from ECB Governing Council statements between 2006 and 2016. The analysis reveals that ECB sentiments on ‘economic outlook’ are more consequential for money market (MM) liquidity than for currency, equity and bond (CEB) liquidity. Sentiments on ‘monetary policy’ produce a statistically significant effect on CEB liquidity; with more ‘hawkish’ sentiments leading to declines in liquidity. Volatility in global financial markets, however, plays a relatively more robust role than ECB sentiments in influencing market liquidity. The results are corroborated using an alternative and more generic quantifier called the Loughran and McDonald (LM) sentiment quantifier. The specialized lexicon provides richer inferences than the LM quantifier, however, since it captures the ‘hawkishness’ or ‘dovishness’ of monetary policy tone and the ‘positivity’ or ‘negativity’ of the Governing Council’s sentiments on economic outlook.