RDP 2005-02: The Impact of Monetary Policy on the Exchange Rate: A Study Using Intraday Data 4. Conclusions

In this paper we use an event study to isolate the impact of changes in monetary policy on the exchange rate. Two important aspects of our study enable us to abstract from endogeneity and the influence of other exogenous news. First, we use a sample period for four countries (Australia, Canada, New Zealand and the United Kingdom) in which monetary policy does not focus on the exchange rate and the decision is predetermined when it is implemented. Second, we use intraday data with a narrow event window. The results indicate that the exchange rate appreciates on average by around 1½ per cent in response to an unanticipated 100 basis point increase in the policy interest rate. The estimates for individual countries range from 1.0–1.8 per cent. For a 25 basis point surprise this equates to an average appreciation of 0.35 per cent (¼–½ of a per cent for individual countries). These results are slightly smaller than those in Zettelmeyer (2004) but mostly marginally larger than those in Faust, Rogers, Wang and Wright (2003).

The impact of monetary policy changes on the exchange rate is found to occur virtually instantaneously. If we use an event window that ends well after the monetary policy decision, the estimates do not change, indicating that the news is rapidly incorporated into exchange rates, although the standard errors widen. Despite using a narrow event window in which no other identifiable events occurred, the monetary shock explains only 10–20 per cent of the variation in the exchange rate in that short window. In general, the results suggest that monetary policy can account for only a small part of the observed volatility in the exchange rate. The small proportion explained by such high-profile news indicates that there is still much to learn in explaining exchange rate movements.

In the second part of the paper we present new evidence that not all monetary surprises will have the same effect on the exchange rate. Those that cause a revision to expectations of future policy are found to have a much larger impact than surprises in the timing of a change in monetary policy. A 100 basis point (25 basis point) increase in current and future policy interest rates is found to appreciate the exchange rate by around 1.7 per cent (0.4 per cent). Estimates for individual countries range from 1.3–2.2 per cent. In contrast, a monetary surprise that only brings forward an anticipated change in policy is found to appreciate the exchange rate by just 0.9 per cent (0.2 per cent). A rough calculation, subject to the caveat of not knowing the change in the long-run equilibrium exchange rate, suggests that this immediate jump in the exchange rate is over twice as large as uncovered interest parity would suggest, adding to the puzzle of its empirical failure.