Finance and Economics Discussion Series (FEDS)
January 2020 (Revised November 2020)
The Power of Narratives in Economic Forecasts
The sentiment, or “Tonality”, extracted from the narratives that accompany Federal Reserve economic forecasts is strongly correlated with future economic performance, positively with GDP and negatively with unemployment and inflation. Moreover, Tonality conveys incremental information in that it predicts errors in both Federal Reserve and private-sector forecasts of GDP, unemployment, and monetary policy up to four quarters out. Tonality similarly predicts stock returns. Tonality is most informative when uncertainty is high and point forecasts predict subpar growth. Quantile regressions indicate that much of Tonality’s forecasting power arises from its signal of downside risks to economic performance and stock returns.
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