The effects of conventional and unconventional monetary policy on exchange rate volatility

Abstract

This paper examines the impacts of U.S. conventional and unconventional monetary policy announcements on the volatility of six exchange rates, namely Australian dollar, British pound, Canadian dollar, Euro, Japanese yen, and Swiss franc against the U.S. dollar. Narrow windows around policy announcements and high frequency second-by-second intraday data are used in the analysis. Results show that the exchange rate volatility increases significantly in the narrow window before and after the announcements under conventional monetary policy regime. The increase in the volatility is even greater during the contemporaneous period under the unconventional regime. Dividing monetary policy announcements into expansionary and non-expansionary groups, we further find that exchange rate volatility responds stronger to the non-expansionary announcements compared to the expansionary ones under the unconventional monetary policy regime.

Keywords:

• Foreign exchange
• Volatility
• Unconventional Monetary Policy
• Monetary policy announcements
• High-frequency data

JEL classification:

• F31
• G14

PUBLIC INTEREST STATEMENT

Have you ever thrown a rock and/or a feather in water? When a monetary policy announcement is made, exchange rates may react to the announcement by moving up or down, resulting in possible increase in the volatility, just like the ripples as water molecules going up and down caused by a rock or a feather. Some announcements may be like rocks, making the exchange rate more volatile; some announcements may be like feathers, causing insignificant changes. The results show that both conventional and unconventional monetary policy announcements are “rocks”, and unconventional monetary policy “rocks” are even bigger than the conventional ones. This paper contributes to the understanding of the stability of the foreign exchange market, the biggest financial market in the financial system, and also provides policymakers with insights into the impacts of different monetary policy.

Acknowledgements

The data used in this paper was funded by a research grant from the Western Michigan University Graduate School.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1. In all fairness, nominal interest rates can go below zero as was the case of a different policy experiment undertaken by the European Central Bank (ECB) “Lowering the rate on overnight bank deposits at the ECB into negative territory–effectively forcing banks to pay to deposit excess funds–would put the ECB into uncharted territory as the first major central bank to experiment with such a policy. A negative rate could encourage banks to lend money to each other but could also have adverse effects on bank profits.” (Blackstone, Brian and Lawton, Christophoer, “ECB’s Sabine Lautenschläger: Open to Negative Rates, Asset Purchases,” The Wall Street Journal, 10 March 2014). For more on this type of policy, see Bech and Malkhozov 2016 and Heider et al 2019.

2. Bank of England started Quantitative Easing in November 2009 and the last round of QE was in August 2016. https://www.bankofengland.co.uk/monetary-policy/quantitative-easing. The European Central Bank conducted QE from March 2015 to December 2018. https://www.ecb.europa.eu/mopo/implement/omt/html/index.en.html

3. http://www.forextickdata.com/

4. http://www.federalreserve.gov/monetarypolicy/fomc_historical.htm

5. Table 5 displays the average volatility during different periods pre and post November 2008 to provide a simple and clear comparison of the volatilities.

6. The recession begun in December 2007 and officially ended in June 2009, according to the Business Cycle Dating Committee of the National Bureau of Economic Research, the official arbiter of such dates. http://www.nber.org/cycles/sept2010.html

7. http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm

8. http://www.federalreserve.gov/newsevents/press/monetary/20090318a.htm

9. http://www.federalreserve.gov/newsevents/press/monetary/20100316a.htm

10. http://www.federalreserve.gov/newsevents/press/monetary/20100127a.htm

11. http://www.federalreserve.gov/newsevents/press/monetary/20110921a.htm

Additional information

Notes on contributors

Wan Wei

Wan Wei is an assistant professor of economics in the College of Business at Arkansas Tech University. Her research interests include exchange rate behavior, monetary policy, and housing market.

Susan Pozo

Susan Pozo is a professor of economics in the Department of Economics, and the director of Global and International Studies at Western Michigan University. Her areas of expertise include immigration policy, undocumented migration, returns to international human capital, determinants and economic impacts of worker’s remittances, empirical distribution of foreign exchange rates and measures of exchange risk, underground financial and economic activity. This paper sheds light on the relationship between monetary policy and foreign exchange market and provides important implications for policymakers and market participants. This paper also provides other central banks with important information to proceed in their implementation of unconventional monetary policy.