NEWS Release - Monetary policy, exchange rates and capital flows - Speech by Benoît Cœuré, Member of the Executive Board of the ECB, at the 18th Jacques Polak Annual Research Conference hosted by the International Monetary Fund, Washington D.C., 3 November 2017
Central bank asset purchase programmes are often catalysts for significant cross-border capital flows. [1] By compressing the (excess) return on domestic bonds, they encourage investors to rebalance their portfolios towards foreign, higher yielding assets.[2]
Such capital flows have reached historical dimensions in the case of the ECB’s asset purchase programme (APP), with both resident and non-resident investors moving out of euro-denominated securities and into bonds issued predominantly by the safest non-euro area sovereigns. I examined these flows in detail in a recent speech at the ECB’s Foreign Exchange Contact Group meeting.[3]
One intriguing observation I made in this speech was that there was no evidence of a causal link between such capital flows and exchange rate movements. Findings based on event studies instead suggest that, around the time of central bank asset purchase announcements, investors price the exchange rate mainly on the basis of the information these programmes provide to markets about the expected future path of short-term interest rates. In this sense, the effect of asset purchases on exchange rates is not fundamentally different from that of conventional interest rate policy.
Today I would like to build on this previous contribution and provide further insights into the channels through which central bank asset purchase programmes are likely to affect the exchange rate. I will provide suggestive evidence that challenges the widely held view in the event-study literature that policy-induced portfolio rebalancing does not affect the exchange rate.[4] My remarks therefore confirm that portfolio rebalancing is a major transmission channel of central bank asset purchase programmes and provide some tentative support to theories of exchange rate determination in imperfect financial markets, which give a first-order role to capital flows.[5]
Unlike private portfolio rebalancing, however, central bank asset purchase programmes can be anticipated by investors. This means that exchange rates should adjust in a way that clears the expected future supply of and demand for currency resulting from anticipated cross-border capital flows. The implication is that asset purchase programmes may, at times, break the link between future expected short-term rates and the exchange rate.
Before developing this argument in more detail, allow me to reiterate at this point that the exchange rate is not a policy target for the ECB. It is one channel of transmission through which our monetary policy actions achieve price stability in the medium term, in both conventional and unconventional times. It is therefore important that practitioners and academics alike better understand how this channel propagates policy stimulus through financial markets, within and across economies.
The zero lower bound, forward guidance and exchange rates
Let me start by briefly recalling the two main propositions I made in my earlier remarks in July. One was that there is compelling empirical evidence that central bank asset purchase programmes are often associated with substantial cross-border capital flows. My first slide illustrates this point quite clearly for the euro area.
The second proposition was that asset purchases affect the exchange rate in broadly the same way as conventional monetary policy – that is, through expectations of interest rate differentials. To date, there is very little evidence to suggest that currency movements are a direct consequence of the impact on the supply of and demand for currency when investors rebalance their portfolios across borders.
It is this second proposition that I would like to examine today in greater detail.
In doing so, it is helpful to start by recalling the basic relationship between exchange rates and interest rate movements. I do this on the second slide. On the left-hand side you can see that, in the past, there has often been an intimate relationship between short-term interest rate differentials – measured here using bonds with a maturity of two years – and movements in the exchange rate, at least for the euro and US dollar pair. The correlation between the two series was a remarkable 0.85 during the period 2005 to 2011.
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