A Fundamental Connection: Exchange Rates and Macroeconomic Expectations
An emerging perception in international economics is that exchange rates are disconnected contemporaneously from macroeconomic fundamentals and are instead more closely tied to financial variables, particularly asset prices. The authors argue that this notion is incorrect. They use novel econometric methods to show that, while quarterly exchange rate changes are tightly linked to movements in currency risk premia, new information revealed by announcements about macroeconomic indicators can explain much of the variation in these risk premia. They also show that this same macroeconomic news also explains most of the variation in exchange rate changes at a quarterly frequency and that this news has even greater explanatory power during economic downturns and periods of financial uncertainty.
- Since 2001, when the data used in the authors’ analysis begin, macroeconomic news has been able to explain about 70 percent of the variation in quarterly exchange rate changes for nine advanced economy currencies against the US dollar.
- Of the various exchange rate change components (related to changes in expectations about currency risk premia, short-term policy rates, and inflation), the currency risk premium component is the most volatile, exhibiting about the same degree of volatility as the nominal exchange rate change itself.
- Macroeconomic news can explain 51 percent of the variation in the currency risk premium component.
- During US recessions, macroeconomic news explains 84 percent of the variation in quarterly exchange rate changes compared with 65 percent during normal times.
This paper’s findings challenge the idea that there is a disconnect between exchange rates and macroeconomic fundamentals and call for theories that connect currency risk premia, as well as exchange rate changes more broadly, to those fundamentals.
This paper presents new stylized facts about exchange rates and their relationship with macroeconomic fundamentals. We show that macroeconomic surprises explain a large majority of the variation in nominal exchange rate changes at a quarterly frequency. Using a novel present value decomposition of exchange rate changes that is disciplined with survey forecast data, we show that macroeconomic surprises are also a very important driver of the currency risk premium component and explain about half of its variation. These surprises have even greater explanatory power during economic downturns and periods of financial uncertainty.