Benoît Coeuré: Monetary policy, exchange rates and capital flows
Speech by Mr Benoît Coeuré, Member of the Executive Board of the European Central Bank, at
the 18th Jacques Polak Annual Research Conference, hosted by the International Monetary
Fund, Washington DC, 3 November 2017.
* * *
I would like to thank T. Kostka, A. Mehl, I. Van Robays and J. Gräb for their contributions to this
speech. I remain solely responsible for the opinions contained herein.
Central bank asset purchase programmes are often catalysts for significant cross-border capital
flows. By compressing the (excess) return on domestic bonds, they encourage investors to
1
rebalance their portfolios towards foreign, higher yielding assets. 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
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detail in a recent speech at the ECB's Foreign Exchange Contact Group meeting.
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
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rate. 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
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flows.
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.
Admittedly, academics typically take this correlation much less seriously than practitioners. It is a
good habit of academics to dismiss contemporaneous correlations between two variables as
spurious. If anything, standard theory - also known as uncovered interest parity (UIP) - predicts
a correlation between today's interest rate differentials and tomorrow's exchange rate changes,
thereby discrediting any perceived contemporaneous causality.
Other approaches are less dismissive, however. The "asset market approach" to exchange
rates, for example - which, in essence, is an alternative representation of the UIP - posits that,
as an asset price, exchange rates should fully reflect today's expectations about the future, just
as equity prices reflect the expected discounted stream of future earnings and other relevant
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information.
The implication is that the current level of the exchange rate should be a function of the average
of current and future expected short-term interest rates. And because monetary policy, away
from the zero lower bound, predominantly sends signals about the current level of central bank
interest rates, and because the term premium - the additional return that investors demand for
the risks incurred by not simply rolling over a series of short-term bonds - was typically
contained at shorter horizons, it is not surprising to see a strong correlation between short-term
interest rates and the exchange rate.
Long-term interest rate differentials, by contrast, have usually carried less informational content
to explain exchange rate movements. You can see this on the right-hand side of this slide. There
was a connection, but it was looser, around 0.65, likely reflecting the growing role of term premia
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along the term structure of interest rates.
So, prima facie, empirical evidence suggests that monetary policy, by influencing short-term
interest rate differentials, could directly affect the exchange rate and, hence, real activity and
prices. A natural question to ask, then, is whether monetary policy may have lost some of its
potency once interest rates reached the zero lower bound. That is, policy might have become
less effective once it started working its way mainly through long-term, rather than short-term,
interest rates, via, for example, sovereign bond purchases.
Simple visual inspection of the chart on the left suggests it has indeed. As two-year interest rates
approached the zero lower bound - around end-2011 - their correlation with the exchange rate
effectively broke down. Long-term rates, at least initially, also seem to have provided little to no
information as to where the exchange rate was heading, as the chart on the right suggests.
This interpretation warrants closer inspection, however, as this period coincided with the growing
use of unconventional monetary policy measures by central banks worldwide. Indeed, I will argue
that in order to understand how unconventional policy affects the exchange rate at, or close to,
the lower bound, it is useful to break down long-term yields into their two main components - the
expectations component and the term premium.
Slide 3 shows the insights that can be gained from this breakdown. Here I focus on the period
2012 to 2014. During this period, short-term rates barely moved, as you saw on the previous
slide, while the long-term interest rate differential was by and large disconnected from exchange
rate movements - you can see this clearly again on the left-hand side.
But now consider the right-hand chart. Here I plot the exchange rate against the differential of the
expectations component of ten-year interest rates as extracted from dynamic term structure
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models. Put simply, it is the same ten-year rate differential as on the left-hand chart, only
corrected for the term premium estimate.
The correlation during 2012 and 2013 is compelling, at around 0.75. Shortly before the crisis, in
2005 and 2006, the correlation was less than 0.4. Incidentally, the close relationship coincides
with a considerable strengthening of central banks' forward guidance on interest rates. The
Federal Reserve, for example, introduced date-based forward guidance in mid-2011 and adopted
state-contingent guidance in late 2012. The ECB, for its part, introduced rate forward guidance
for the first time in July 2013, one year before it announced its credit easing programme.
So, what could have happened is that market participants, trusting central banks' forward
guidance that policy rates would stay at very low levels for an extended period, were increasingly
pricing exchange rates on the basis of information about how policy would evolve in the more
distant future. That is, with short-term rates broadly stable, the weight investors attached to the
expected future path mechanically increased - just as theory would predict.
Term structure models can therefore provide compelling evidence that exchange rates remain
deeply connected to monetary policy also when interest rates are at, or close to, the effective
lower bound, even if interest rate differentials per se suggest a structural break in the
relationship.
Asset purchases and exchange rates
But the right-hand chart also suggests that this is not the full story. A clear break emerged in late
2013. And that break is likely related to the second policy instrument I mentioned before, namely
asset purchases. Although asset purchases, by removing duration risk from the market, act
primarily on the term premium, they also entail a strong signalling channel, in particular at, or
close to, turning points.
For example, the Federal Reserve's decision to start tapering in December 2013 triggered an
appreciable increase in future expected short-term rates. You can see on the right-hand side that
the ten-year expectations component differential vis-à-vis the euro area widened by more than 50
basis points in just a few months. This should have caused the US dollar to appreciate, at least
on the basis of past behaviour.
The dollar defied upward pressure, however. It continued to depreciate persistently, despite the
marked widening in future expected interest rates. One reason why this might have been the
case is that the signalling and the portfolio rebalancing channels of asset purchases might have
worked in opposite directions. In imperfect markets, investors may give different weights to
conflicting information.
What I mean by this is that, despite expectations of a significant increase in policy rates, the
Federal Reserve's very gradual slowdown of its pace of Treasury and mortgage-backed
securities purchases - which caught many investors on the wrong foot after the "taper tantrum"
- possibly fuelled expectations that long-term rates, and hence also foreign demand for
USdenominated interest-bearing assets, would remain contained for a considerable period.
This interpretation is consistent with at least four observations: first, term premia on US bonds
fell notably after the Federal Reserve started tapering in December 2013, pointing to a correction
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of the sharp uptick in term premia after the "taper tantrum". Second, investors did not expect the
US dollar to appreciate. CFTC data show that they continued to hold net short speculative
positions in the US dollar well into 2014. Third, capital inflows into the US Treasury market did
indeed decelerate somewhat during the first half of 2014, validating earlier expectations. And,
fourth, the dollar started to appreciate only once expectations about asset purchases in the euro
area gained a strong tailwind during the second half of 2014.
Here the temporal coincidence is striking. The moment the ECB announced its credit easing
programme in June 2014, which many observers considered to be a harbinger of sovereign bond
purchases, and moved rates into negative territory, the dollar started to appreciate significantly
against the euro.
In less than two and a half months, the euro lost nearly 10% in value. Net euro short positions
jumped to close to record highs in the space of a few weeks. In other words, only the prospect of
sovereign bond purchases by the ECB seems to have led to a reappraisal by market participants
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of future domestic and foreign demand for US Treasuries.
Empirical analysis on the direction of international spillovers in bond markets corroborates this
view. On slide 4 you can see that ECB researchers, using the Diebold-Yilmaz methodology, find
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that spillovers from the euro area to the United States spiked sharply in mid-2014. According to
this methodology, euro area spillovers accounted for more than half of the variance in US
Treasuries in the second half of 2014.
Put differently, in the presence of asset purchase programmes, the portfolio rebalancing channel,
rather than the signalling channel, might ultimately rise to become the dominant driver of
exchange rates, at least temporarily. Expectations of compressed term premia, either through
central bank actions directly, or through cross-border capital flows associated with such
programmes, or both, can offset, or mitigate, the impact of changes in the expectations about
future short-term rates on exchange rates.
Disconnects may also be the result of market segmentation, much in line with the view that the
financial market comprises a heterogeneous set of actors with very different beliefs and
expectations. Indeed, the same chart suggests that spillovers from the euro area to the US bond
market had already accelerated sharply in the first half of 2014. So, a good part of the decline in
US term premia during this period - you can see this on the right-hand side - might in fact have
reflected expectations about monetary easing in the euro area, paired with a reappraisal of the
Federal Reserve's policies.
In other words, during this period participants in the bond market might have held, on average, a
different view on the prospects of global monetary policy from that of their counterparts in the
foreign exchange market, which maintained sizeable net long positions in the euro. Christopher
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Sim's "rational inattention" comes to mind.
This can also be seen on the next slide. Here I show a breakdown of the historical drivers of the
euro and US dollar exchange rate based on a Bayesian VAR developed by researchers at the
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ECB. The shocks are identified using standard sign restrictions. The breakdown suggests that,
by contrast with the spillovers we saw in the previous chart, monetary policy shocks seem to
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have contributed comparatively little to exchange rate movements in the first half of 2014.
Instead, an exogenous shock, which can be interpreted in the context of this discussion as a
time-varying risk premium shock, appears to have put mainly downward pressure on the dollar.
To the extent that risk premium and bond term premium shocks are driven by the same
fundamentals, this would be consistent with the view that the signalling and portfolio rebalancing
channels were sending conflicting signals.
This train of thought is in fact very similar to the view put forward by Charles Engel and Kenneth
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West on the relationship between risk premia and the exchange rate. They saw the dollar
depreciation in 2007 as evidence of investors thinking "this is a US crisis". And they saw the
dollar appreciation in 2008 as a change in this thinking to "well, this is actually more of a global
crisis".
As with the events of 2007-08, what ultimately caused the initial resilience of the dollar and the
sharp fall in term premia in 2014 will remain a matter of speculation. Factors other than the
actions of the Federal Reserve and the ECB are likely to have contributed to these
developments. But that is not my point. My point is rather that it is not surprising that central bank
asset purchases may break with some of the regularities we have become used to.
The reason is that asset purchases are monetary policy actions that can be anticipated by
market participants, just like changes in key policy rates. Unlike conventional monetary policy,
however, they have direct implications for the expected supply of and demand for internationally
traded bonds and, hence, for the level of the exchange rate that, all other things being equal,
clears the resulting capital flows.
This may, at times, break the link between future expected rates and the exchange rate. This is
clearly visible when we look at slide 6. The chart is based on the same methodology as the
spillover chart on slide 4, but it illustrates how much, on average, of the variance in long-term
bond yields in one country can be explained by the other country's term premium and expected
short-term rates respectively.
You can see that the moment short-term yields hit the zero lower bound, spillovers in bond
markets by and large reflected term premia movements - in both directions. These spillovers
may pull the exchange rate away from the path implied by expectations about the future
shortterm rate. The extent of the decoupling, in turn, will depend on the expected direction,
persistence and degree of international spillovers - something that is inherently difficult to project
and price.
In this sense, the implications are very similar to those described by Xavier Gabaix and Matteo
Maggiori in their 2015 Quarterly Journal of Economics article, which states that the risk-bearing
capacity of financial intermediaries provides a role for capital flows to affect the exchange
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rate. The difference is only that if asset purchases are understood by investors to be part of the
reaction function of central banks, then the exchange rate can be expected to adjust before
capital flows take place. This is certainly what we have seen in the euro area.
This also means that we should treat more carefully findings in the event-study literature that
assign most of the observed exchange rate change around central bank asset purchase
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announcements to the signalling channel. Given that intermediaries are forward-looking but
constrained by their balance sheets, policy-induced exchange rate changes can also be
expected to reflect expectations of future cross-border capital flows and their associated impact
on the future supply of and demand for currency.
In this sense, the debate also shares some similarities with a related strand of the literature,
namely the transmission channels of sterilised foreign exchange interventions. The view that
such interventions are effective mainly by signalling future policy intentions is frequently
challenged by empirical evidence suggesting that portfolio rebalancing may have economically
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relevant effects.
Of course, this does not mean that understanding the potential spillovers of central bank asset
purchase programmes is enough to explain exchange rate movements. Changes in relative term
premia are far more difficult to interpret than changes in the expected path of future short-term
interest rates. The latter can be clearly associated with changes in monetary policy expectations.
Changes in term premia, by contrast, often reflect a combination of shocks, including monetary
policy shocks as well as shocks to demand, risk aversion and other variables, which will drive
term premia in the same or in opposite directions.
The most recent disconnect between the euro and US dollar exchange rate and the expected
future short-term interest rate differential is a case in point. On the left-hand side of slide 7 you
can see that a significant gap between the two series re-emerged in the spring of this year, and
continues to persist.
It is tempting to link recent developments once more to portfolio rebalancing considerations. After
all, the Federal Reserve is now actively reducing its balance sheet, while the ECB last week
decided to extend its asset purchase programme by nine months, or more, if needed, while
reducing the monthly pace to €30 billion. This might have caused some investors to expect a
gradual rebalancing of portfolios away from US dollar-denominated assets and towards
eurodenominated assets, which would support the euro.
But many other factors may drive interest and exchange rates, with likely different implications for
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the real economy. Indeed, geopolitical and policy uncertainties may also contribute to swings in
bond term premia. So it is difficult to establish unequivocal links. But, if we look at the right-hand
side of this slide, it is intriguing to see such a close relationship between the exchange rate and
relative bond term premia differential as that observed during the course of this year.
Conclusion
Let me conclude.
Deciphering exchange rate movements, and giving them a structural interpretation, remains a
topic that requires the dedication and passion of many researchers. Much has already been
learned, but much still remains to be understood. The introduction of unconventional monetary
policy measures forces us to think more deeply about the channels through which such
measures affect the exchange rate, with regard to their impact both on the expected future path
of short-term interest rates and on risk premia.
An important aspect in this endeavour is to gain a better understanding of the role of portfolio
rebalancing. Evidence is growing, and my remarks today are intended to add to this, that portfolio
rebalancing is a major transmission channel of central bank asset purchases. At the same time,
the signalling and portfolio rebalancing channels of central bank asset purchase programmes
might, at times, work in opposite directions, with unclear implications for the exchange rate.
Moreover, in an integrated global financial system, unconventional policy measures have been
shown to often trigger large cross-border capital flows. To the extent that such policies can be
anticipated by market participants, financial intermediaries could be expected to price in the
resulting shift in the relative supply of and demand for currency before capital flows take place.
As a consequence, international portfolio rebalancing considerations may, at times, drive a
wedge between expected future short-term rates and the exchange rate.
My remarks today are by no means conclusive and they are based on tentative evidence. But I
hope that they provide impetus to further, more systematic research on a topic that is not only
intriguing from an intellectual perspective, but also of significant relevance to policymakers in
their efforts to improve the understanding of the transmission channels of non-standard
monetary policy measures.
Thank you for your attention.
1
See e.g. Fratzscher, M., M. Lo Duca and R. Straub (2016), "ECB Unconventional Monetary Policy: Market Impact
and International Spillovers", IMF Economic Review, 64(1), pp. 36-74; Georgiadis, G. and J. Gräb (2016), "Global
Financial Market Impact of the Announcement of the ECB's Asset Purchase Programme", Journal of Financial
Stability, 26, pp. 257-265; Rajan, R. (2014), "Competitive monetary easing: is it yesterday once more?", remarks
at the Brookings Institution, Washington, D.C., April 10; and Bernanke, B.S. (2015), "Federal Reserve Policy in an
International Context", paper presented at the 16th Jacques Polak Annual Research Conference hosted by the
International Monetary Fund, Washington, D.C., 5 and 6 November.
2
See Coeuré, B. (2017), "The international dimension of the ECB's asset purchase programme", speech at the
ECB's Foreign Exchange Contact Group meeting, Frankfurt am Main, 11 July.
3
See e.g. Fratzscher et al. (2016, op.cit.) and Georgiadis, G. and J. Gräb (2016, op.cit.).
4
See e.g. Gabaix, X. and M. Maggiori (2015), "International Liquidity and Exchange Rate Dynamics," Quarterly
Journal of Economics, 130(3), pp. 1369-1420; and Hau, H. and H. Rey (2004), "Can Portfolio Rebalancing
Explain the Dynamics of Equity Returns, Equity Flows, and Exchange Rates?", American Economic Review, 94,
pp. 126-133.
5
See e.g. Engel, C. and K.D. West (2005), "Exchange Rates and Fundamentals", Journal of Political Economy,
vol. 113(3), pp. 485-517; Froot, K.A. and T. Ramadorai (2005), "Currency Returns, Intrinsic Value, and
Institutional-Investor Flows", Journal of Finance, 60, pp. 1535-1566; and Engel, C. and K. West (2010), "Global
Interest Rates, Currency Returns, and the Real Value of the Dollar", American Economic Review, 100, pp.
562567.
6
A second explanation could be that exogenous monetary policy shocks may have less impact on long-term
interest rates (see e.g. Evans, C.L. and D.A. Marshall (1998), "Monetary Policy and the Term Structure of
Nominal Interest Rates: Evidence and Theory", Carnegie Rochester Series on Public Policy, 49, 1998, pp. 53-
111).
7
For more details on estimates of US term premia, see e.g. Adrian, T., R. Crump and E. Moench (2013), "Pricing
the Term Structure with Linear Regressions", Journal of Financial Economics, 110, pp. 110-138. For the euro
area term premia, the breakdown is based on an affine term structure model fitted to the euro area OIS curve
using the method described in Joslin, S., K. Singleton and H. Zhu (2011), "A New Perspective on Gaussian
Dynamic Term Structure Models", Review of Financial Studies, 24, pp. 926-970.
8
The evidence presented here seems at odds with the predictions made in Galí, J. (2017), "Forward Guidance
and the Exchange Rate", mimeo.
9
This happened despite US medium-term inflation expectations as well as crude oil prices moving mostly
sideward during this period, with a stable world economic outlook as depicted by the IMF.
10
Many market commentaries also considered that the speech by ECB President Mario Draghi in August 2014 in
Jackson Hole provided signals that the ECB was considering purchases of sovereign bonds in response to a
destabilisation of medium-term inflation expectations. See Draghi, M. (2014), "Unemployment in the euro area",
speech at the annual central bank symposium in Jackson Hole, 22 August.
11
For more details about the methodology, see Diebold, F.X. and K. Yilmaz (2012), "Better to Give than to Receive:
Predictive Directional Measurement of Volatility Spillovers", International Journal of Forecasting, 28, pp. 57-66.
12
See Sims, C. (2003), "Implications of Rational Inattention", Journal of Monetary Economics, 50 (3), pp. 665-90.
The ability of the foreign exchange markets to process all relevant information has been subject to close
scrutiny, see e.g. Froot, K.A. and R.H. Thaler (1990), "Anomalies: Foreign Exchange", Journal of Economic
Perspectives, 4 (3), pp. 179-92.
13
See also Coeuré, B. (2017), "The transmission of the ECB's monetary policy in standard and non-standard
times", speech at the workshop "Monetary policy in non-standard times", Frankfurt am Main, 11 September.
14
This is apparent when the first two quarters of 2014 are put together in the chart on slide 5.
15
See Engel, C. and K. West (2010, op.cit.).
16
See Gabaix, X. and M. Maggiori (2015, op.cit.).
17
See e.g. Rogers, J., C. Scotti and J. Wright (2014), "Evaluating Asset-Market Effects of Unconventional Monetary
Policy: A Cross-Country Comparison", International Finance Discussion Papers 1101, Board of Governors of the
Federal Reserve System; Fratzscher et al. (2016, op.cit.); and Georgiadis, G. and J. Gräb (2016, op.cit.).
18
See Sarno, L. and M. Taylor (2001), "Official Intervention in the Foreign Exchange Market: Is It Effective and, If So,
How Does It Work?", Journal of Economic Literature; and Blanchard, O., G. Adler and I. de Carvalho Filho (2015),
"Can Foreign Exchange Intervention Stem Exchange Rate Pressures from Global Capital Flow Shocks?", NBER
Working Paper21427. Non-sterilised interventions, which in spirit are closest to central bank asset purchase
programmes, are widely considered to be effective through both channels (see e.g. Chinn, M. (2017), "The Once
and Future Global Imbalances? Interpreting the Post-Crisis Record", paper presented at the annual central
bank symposium in Jackson Hole, August).
19
See Coeuré, B. (2017, op.cit.).