benoit cœure : monetary policy, exchange rates and capital flows speech by mr benoit cœure, 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. grab 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 rebalance their portfolios towards foreign, higher yielding assets. 1 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. 2 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. 3 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. 4 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

know exactly the speed at which the economy is actually growing. the statistics that we use when forecasting economic growth contain errors, do not provide a comprehensive picture of the economic situation and furthermore are produced with a lag. another problem is the difficulty in knowing exactly how long it takes before a rate adjustment has the desired effect. since it takes time – we allow for a time horizon of one to two years before the transmission mechanism has worked through the economic system – we have to form an opinion of the state of the economy in the long run. predicting the future is difficult for many reasons, not just due to statistical shortcomings but also because the economy is changing all the time. the economy can be hit by different kinds of shocks, e. g. the increased electricity prices when there was a shortage of water in sweden ’ s reservoirs, and the price of meat and other food when cows in europe were affected by a number of diseases. it is difficult to determine early on what changes in the economy are temporary and what are permanent. another factor complicating the picture is that inflation expectations in society greatly influence price and wage formation, and thereby inflation. in other words the car – to continue with the analogy – has a fogged windscreen, a speedometer that is very difficult to read and pedals that sometimes are sluggish and sometimes easy to push down. how can we make the economy go at an appropriate speed? in somewhat simplified terms there are two different ways to describe monetary policy based on inflation targeting : the first is to employ a simple monetary policy rule whereby the policy rate is set as a function of the current inflation rate and the output gap, which is a measure of the difference between actual and potential output and reflects resource utilisation in the economy. 1 when the output gap is negative, actual output is lower than potential output, which means that there are plenty of spare resources in the economy. in such a scenario price and wage increases are small and inflation is generally below target. when the output gap is positive the situation is the reverse : resources are overstretched and the excessive demand generates inflationary pressures in the economy. so according to the rule the policy rate should be raised if growth is above its potential rate and inflation is higher than the inflation target, and vice versa in the reverse situation. when actual and potential output are the same the economy is in balance and inflation is normally in line with the target, provided that policy is credible. a common argument