Establishing Credibility: Evolving Perceptions of the European Central Bank

The credibility of a central bank’s anti-inflation stance, a key determinant of its success, may reflect institutional structure or, more dynamically, the history of policy decisions. The first years of the European Central Bank (ECB) provide a natural experiment for considering whether, and how, central bank credibility evolves. In this paper, we present a model demonstrating how the high-frequency response of asset prices to news reflects market perceptions of the anti-inflation stance of a central bank. Empirical tests of this model on high frequency data, regressing both the change in the slope of the German yield curve and the change in the euro/dollar exchange rate on the surprise component of price news, suggest significant instability in the market’s perception of the policy stance of the ECB during its first five years of operation. Estimated smoothed paths of the coefficients linking news to asset prices show that these coefficients change with policies undertaken by the ECB. In contrast, there is no evidence of parameter instability for the response of the slope of the United States yield curve to price news during this period, suggesting no comparable evolution in the market perceptions of the commitment to inflation fighting by the Federal Reserve.