Do Exchange Rates Respond to Day-to-day Changes in Monetary Policy Expectations When No Monetary Policy Changes Occur?

Abstract

Recent contributions to the literature on monetary policy and exchanges rates have shown that exchange rates respond to the unexpected element of an actual monetary policy change. This paper addresses whether exchange rates respond to changes in expectations of future US monetary policy when no actual monetary policy changes occur. In order to test the hypothesis that changes in expectations of future monetary policy matter for daily exchange rate determination, we employ data on Federal funds futures contracts for extracting a measure of policy expectations, control for the surprise element of macroeconomic news and policy developments, and analyze more than 12 years of daily exchange rate data. Our findings suggest that continuous day-to-day changes in expectations of future monetary policy have a significant and systematic impact on day-to-day changes in exchange rates even when no actual monetary policy changes occur. This finding implies that monetary policy matters for daily exchange rate determination in more ways than merely through infrequent, actual policy changes. Consistent with the existing literature, we also show that exchange rates respond to actual monetary policy changes and, in particular, that only the unexpected element of a policy change matters.