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Euro-US Dollar Exchange Rate Dynamics at the Effective Lower Bound

Eric McCoy

No 55, European Economy - Economic Briefs from Directorate General Economic and Financial Affairs (DG ECFIN), European Commission

Abstract: In the aftermath of the Global Financial Crisis (GFC), central bank policy rates edged closer to their effective lower bound – the point beyond which central banks cannot or do not want to lower rates further due to economic reasons or institutional constraints. Central banks therefore had to move beyond conventional policy instruments and instead resort to using unconventional tools such as large-scale asset purchase programs. With policy rates stuck at their effective lower bound for an extended period of time, central bankers and academics started to investigate the channels linking central bank unconventional monetary policy decisions to exchange rate movements. As will be discussed in this paper, extracting the expected policy rate and the term premium components of interest rates using a term structure model contributes to a better understanding of the channels through which the introduction of unconventional monetary policy measures have affected the dynamics of the euro – US dollar (EUR/USD) exchange rate. Empirical evidence is presented showing that the term premium component started to play a predominant role in anchoring EUR/USD developments to unconventional monetary policy, which first began in the US with the US Federal Reserve’s (Fed) QE1 in 2008 and which was later followed in the euro area by the onset of the ECB’s large-scale asset purchase program (APP) in 2015. The ECB’s APP, by compressing the term premium component, has likely triggered portfolio rebalancing and the ensuing cross-border capital flows have exerted a downwards pressure on the EUR/USD. Last but not least, the paper also presents empirical evidence demonstrating that incorporating non-monetary policy variables (relative stock market performance, a measure of domestic sovereign credit risk, as well as relative long-term inflation expectations and oil prices) into the analytical framework enhances significantly the understanding and analysis of EUR/USD developments.

Keywords: Monetary Policy; Term Premia; Financial Markets; Exchange Rates; McCoy. (search for similar items in EconPapers)
JEL-codes: E43 E44 E52 E58 F31 (search for similar items in EconPapers)
Pages: 22 pages
Date: 2020-07
New Economics Papers: this item is included in nep-cba, nep-eec, nep-mac and nep-mon
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