In this sense, the effect of asset purchases on exchange rates is not fundamentally different from that of conventional interest rate policy. Today I would like to build on this previous contribution and provide further insights into the channels through which central bank asset purchase programmes are likely to affect the exchange rate. I will provide suggestive evidence that challenges the widely held view in the event-study literature that policy-induced portfolio rebalancing does not affect the exchange rate.3 My remarks therefore confirm that portfolio rebalancing is a major transmission channel of central bank asset purchase programmes and provide some tentative support to theories of exchange rate determination in imperfect financial markets, which give a first-order role to capital flows.4 Unlike private portfolio rebalancing, however, central bank asset purchase programmes can be anticipated by investors. This means that exchange rates should adjust in a way that clears the expected future supply of and demand for currency resulting from anticipated cross-border capital flows. The implication is that asset purchase programmes may, at times, break the link between future expected short-term rates and the exchange rate. Before developing this argument in more detail, allow me to reiterate at this point that the exchange rate is not a policy target for the ECB. It is one channel of transmission through which our monetary policy actions achieve price stability in the medium term, in both conventional and unconventional times.
This should have caused the US dollar to appreciate, at least on the basis of past behaviour. The dollar defied upward pressure, however. It continued to depreciate persistently, despite the marked widening in future expected interest rates. One reason why this might have been the case is that the signalling and the portfolio rebalancing channels of asset purchases might have worked in opposite directions. In imperfect markets, investors may give different weights to conflicting information. What I mean by this is that, despite expectations of a significant increase in policy rates, the Federal Reserve’s very gradual slowdown of its pace of Treasury and mortgage-backed securities purchases – which caught many investors on the wrong foot after the “taper tantrum” – possibly fuelled expectations that long-term rates, and hence also foreign demand for USdenominated interest-bearing assets, would remain contained for a considerable period. This interpretation is consistent with at least four observations: first, term premia on US bonds fell notably after the Federal Reserve started tapering in December 2013, pointing to a correction of the sharp uptick in term premia after the “taper tantrum”.9 Second, investors did not expect the US dollar to appreciate. CFTC data show that they continued to hold net short speculative positions in the US dollar well into 2014. Third, capital inflows into the US Treasury market did indeed decelerate somewhat during the first half of 2014, validating earlier expectations.