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Over the past year, the Federal Reserve has started a new interest rate hike cycle to tame soaring inflation. Since then, every interest rate decision has been closely watched by the market, as monetary policy moves have substantial impact in shaping market dynamics.

To efficiently grasp changes in the Fed’s policy stance, MacroMicro recently tapped into AI research and has launched two new indices—the MM AI FOMC Statement Hawkish-Dovish Index and the MM AI FOMC Statement Optimism Index. The indices leverage the natural language processing capabilities of large language models (LLMs) to extract and analyze information from FOMC statements, including textual analysis on keywords, attitudes, sentiments, and topics. In the following, we explain what these two indices are and how they can provide insights into the Fed’s stance on monetary policy and economic outlook.

1. Introducing the MM AI FOMC Statement Indices

1) MM AI FOMC Statement Hawkish-Dovish Index: Leveraging AI-driven text embedding technology, the index aims to capture the level of hawkish sentiment conveyed in FOMC statements. The index is calculated by first assessing the similarity between the vector representation of each Fed statement and vectors associated with hawkish and dovish keywords, and then subtracting the similarity to dovish keywords from similarity to hawkish statements. A higher index value represents a more hawkish attitude from the Fed, whereas a lower value indicates a dovish inclination. The maximum historical value is indexed to 100 and the minimum to 0. Here are some of the keywords used in constructing the index:

Hawkish keywords: inflation, tight monetary policy, contracting money supply, high interest rate policy, fiscal discipline, inflation target, etc.
Dovish keywords: economic growth, job market, loose monetary policy, low interest rate policy, expanding money supply, economic stimulus measures, etc.

2) MM AI FOMC Statement Optimism Index: Using similar methodology as the Hawkish-Dovish Index above, this index captures the Fed’s sentiment on future economic outlook based on analysis on FOMC statements. A higher value indicates a more optimistic tone in the Fed’s statement. Note that the Optimism Index does not imply the Fed’s sentiment towards employment or inflation specifically, but evaluates the overall level of positivity expressed in the official statement, based on appearance of words like the following:

Optimistic words: robust, strong, positive, optimistic, improving, resilient, etc.
Pessimistic words: weak, fragile, uncertain, risky, sluggish, recession, etc.

2. Relationship between the Hawkish-Dovish Index and Optimism Index

Comparing past trends of the two indices, we can see that the two indicators tend to move in opposite directions (marked with green shading in the chart). That is, a dovish policy stance is often accompanied with an optimistic economic outlook from the Fed, while a pessimistic view on future economic conditions is often seen alongside a more hawkish stance. This demonstrates the countercyclical nature of the Fed’s forward guidance: at times of economic expansion, while tightening monetary policy to avoid bubbles, the Fed would also signal its intention to hike rates to prevent excessive consumption and investment, which may lead to an overheating economy. On the other hand, during economic downturns, while the Fed tends to employ accommodative monetary policy to simulate economic activity, forward guidance would aim to boost market confidence, so to prevent excessive pessimism which could lead to further reduced spending and a downward spiral in economic activity. That said, there were exceptions where both indicators moved in the same direction, such were the cases during the 2008 financial crisis and the covid-19 pandemic in 2020, both of which were times of crisis and the Fed assumed a dovish but pessimistic stance.

Takeaway from MacroMicro

In Fed's March FOMC statement, the Fed omitted its previous wording of anticipating “ongoing increases in the target range” as appropriate. Instead, the following new phrase was included: “some additional policy firming may be appropriate.” And in the May statement, the whole sentence about “some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive” was removed altogether. This is the first time since November 2022 that the statement is removed, implying that the Fed believes the interest rate level after the May rate hike will be high enough to contain inflation (i.e., to bring real interest rates back into positive territory).

This policy shift is also reflected in the MM AI FOMC Statement indices, with the Hawkish-Dovish Index reversing course from its recent peak and the Optimism Index trending upward. Going forward, besides using economic data like employment and inflation to predict the Fed’s next move, users can also refer to these two AI-empowered indices to monitor whether the shift towards a more dovish stance has materialized.

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