Inflation news, FX reactions, and monetary policy

We recently posted a piece on the negative reaction of exchange rates to good news on inflation. The reaction of exchange rates to different news can be affected by expected monetary policy reactions, but the incorporation of these expectations is not easy to test. Friends at Barclays Bank referred me to some recent research work on this topic, “Is Bad News About Inflation Good News for Exchange Rates: And If So, Can That Tell Us Anything About the Conduct of Monetary Policy” by Richard Clarida and Daniel Waldman. I was impressed by the careful analysis and empirical testing of this piece which provides some very compelling evidence on the interaction between inflation shocks, exchange rates, and monetary policy. The authors compare the reaction of exchange rates to inflation shock for both countries that have inflation targets and those that do not.

The overshooting monetary model of exchange rates as well as purchasing power parity suggests that the impact of an inflation shock should be unambiguous. An unexpected increase in inflation should lead to depreciation in the exchange rate. However, this reaction gets more complex when you account for the possible behavior of the central bank to the shock. If the shock puts inflation above the targeted rate set by the central bank, there should be a swift policy response. If the policy follows a Taylor rule, the monetary authority will raise interest rates and cut money supply which will have the effect of leading to an exchange rate appreciation. Consequently, the reaction of the exchange rate should be a related to the expected monetary policy response. If investors believe that the monetary authority will focus on inflation targeting and the policy is considered credible, then there should be a different reaction than expected from the traditional overshooting model. While the theory for this story has been developed years ago, the authors provide empirical support for the interaction between exchange rates and monetary policy.

This theory can be tested by comparing the reaction of exchange rates to inflation shocks in those countries that have inflation targeting against those that do not. There should be an appreciation in exchange rates with inflation target countries and a depreciation with those that follow a different monetary policy. The authors find a strong appreciation for inflation targeting countries.

The reaction of the exchange rate to an inflation shock also changed for those countries that moved to inflation targeting over the last ten years. For example, the exchange rate reaction in Great Britain and Norway changed and was consistent with other inflation targeters after their change in policies.

This work could be further refined depending on the credibility of the monetary authority and whether the shock is above or below the target or is viewed as temporary or permanent. However, it provides clear support for stories concerning the interaction between exchange rates and expected policy responses.