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Research reveals the role of bellwether companies.
- The Federal Reserve Board uses reams of hard economic data to forecast economic growth and make monetary policy decisions such as setting interest rates and bank reserve requirements.
- The Federal Reserve Board also collects softer qualitative information, like the opinions of business executives who lead so-called bellwether firms whose earnings seem to predict larger trends and play an outsized role in the economy.
- Yet the precise sources of that qualitative information, and how the Fed uses it, have long been shrouded in mystery.
Research by Rice Business Professor K. Ramesh shows that the Fed appears to harvest qualitative information from the accounting disclosures that all public companies must file with the Securities and Exchange Commission.
These SEC filings are typically used by creditors, investors and others to make firm-level investing and financing decisions; and while they include business leaders’ sense of economic trends, they are never intended to guide macro-level policy decisions. But in a recent paper (“Externalities of Accounting Disclosures: Evidence from the Federal Reserve”), Ramesh and his colleagues provide persuasive evidence that the Fed nonetheless uses the qualitative information in SEC filings to help forecast the growth of macroeconomic variables like GDP and unemployment.
According to Ramesh, the study was made possible thanks to a decision the SEC made several years ago. The commission stores the reports submitted by public companies in an online database called EDGAR and records the IP address of any party that accesses them. More than a decade ago, the SEC began making partially anonymized forms of those IP addresses available to the public. But researchers eventually figured out how to deanonymize the addresses, which is precisely what Ramesh and his colleagues did in this study.
"We were able to reverse engineer and identify those IP addresses that belonged to Federal Reserve staff," Ramesh says.
The team ultimately assembled a data set containing more than 169,000 filings accessed by Fed staff between 2005 and 2015. They quickly realized that the Fed was interested only in filings submitted by a select group of industry leaders and financial institutions.
But if Ramesh and his colleagues now had a better idea of precisely which bellwether firms the Fed focused on, they still had no way of knowing exactly what Fed staffers had gleaned from the material they accessed. So the team decided to employ a measure called "tone" that captures the overall sentiment of a piece of text – whether positive, negative, or neutral.
Building on previous research that had identified a set of words with negatively toned financial reports, Ramesh and his colleagues examined the tone of all the SEC filings accessed by Fed staff between one meeting of the Federal Open Markets Committee (FOMC) and the next. The FOMC sets interest rates and guides monetary policy, and its meetings provide an opportunity for Fed officials to discuss growth forecasts and announce policy decisions.
The researchers then examined the Fed's growth forecasts to see if there was a relationship between the tone of the documents that Fed staff examined in the period between FOMC meetings and the forecasts they produced in advance of those meetings.
The team found close correlations between the tone of the reports accessed by the Fed and the agency’s forecasts of GDP, unemployment, housing starts and industrial production. The more negative the filings accessed prior to an FOMC meeting, for example, the gloomier the GDP forecast; the more positive the filings, the brighter the unemployment forecast.
Ramesh and his colleagues also compared the Fed's forecasts with those of the Society of Professional Forecasters (SPF), whose members span academia and industry. Intriguingly, the researchers found that while the errors in the SPF's forecasts could be attributed to the absence of the tonal information culled from the SEC filings, the errors in the Fed’s forecasts could not. This suggests both that the Fed was collecting qualitative information that the SPF was not—and that the agency was making remarkably efficient use of it.
"They weren’t leaving anything on the table," Ramesh says.
Having solved one mystery, Ramesh would like to focus on another; namely, how does the Fed identify bellwether firms in the first place?
Unfortunately, the SEC no longer makes IP address data publicly available, which means that Ramesh and his colleagues can no longer study which companies the Fed is most interested in. Nonetheless, Ramesh hopes to use the data they have already collected to build a model that can accurately predict which firms the Fed is most likely to follow. That would allow the team to continue studying the same companies that the Fed does, and, he says, “maybe come up with a way to track those firms in order to understand how the economy is going to move.”
K. Ramesh is Herbert S. Autrey Professor of Accounting at Jones Graduate School of Business at Rice University. The study is co-authored with Assistant Professor Gary Lind of the University of Pittsburgh and Associate Professors Edward Li and Min Shen of the Baruch College. Dr. Gary Lind is a graduate of the doctoral program at the Jones Graduate School of business.
To learn more, see: Li, Edward Xuejun and Lind, Gary and Ramesh, K. and Shen, Min, “Externalities of Accounting Disclosures: Evidence from the Federal Reserve” (2023). The Accounting Review: https://ssrn.com/abstract=3179251 or http://dx.doi.org/10.2139/ssrn.3179251.