Benoît Cœuré: Monetary policy, exchange rates and capital flows Speech by Mr Benoît Cœuré, 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. Gräb 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.
It is therefore important that practitioners and academics alike better understand how this channel propagates policy stimulus through financial markets, within and across economies. The zero lower bound, forward guidance and exchange rates Let me start by briefly recalling the two main propositions I made in my earlier remarks in July. One was that there is compelling empirical evidence that central bank asset purchase programmes are often associated with substantial cross-border capital flows. My first slide illustrates this point quite clearly for the euro area. 1 / 11  BIS central bankers' speeches  The second proposition was that asset purchases affect the exchange rate in broadly the same way as conventional monetary policy – that is, through expectations of interest rate differentials. To date, there is very little evidence to suggest that currency movements are a direct consequence of the impact on the supply of and demand for currency when investors rebalance their portfolios across borders. It is this second proposition that I would like to examine today in greater detail. In doing so, it is helpful to start by recalling the basic relationship between exchange rates and interest rate movements. I do this on the second slide. On the left-hand side you can see that, in the past, there has often been an intimate relationship between short-term interest rate differentials – measured here using bonds with a maturity of two years – and movements in the exchange rate, at least for the euro and US dollar pair.