Working Paper: NBER ID: w28420
Authors: Charles Engel; Ekaterina Kazakova; Mengqi Wang; Nan Xiang
Abstract: We re-examine the time-series evidence for failures of uncovered interest rate parity on short-term deposits for the U.S. dollar versus major currencies of developed countries at short-, medium- and long-horizons. The evidence that interest rate differentials predict foreign exchange risk premiums is fragile. The relationship between interest rates and excess returns is not stable over time and disappears altogether when nominal interest rates are near the zero-lower bound. However, we do find evidence that year-on-year inflation rate differentials consistently predict excess returns – when the U.S. dollar y.o.y. inflation rate has been relatively high, subsequent returns on U.S. deposits tend to be high. We interpret this evidence as being consistent with hypotheses that posit that markets do not fully react initially to predictable changes in future monetary policy. Interestingly, the predictive power of relative y.o.y. inflation only begins in the mid-1980s when central banks began to target inflation more consistently and continues in the post-ZLB period when interest rates lose their primacy as a policy instrument. However, we caution not to rule out the possibility that excess returns are not predictable at all.
Keywords: No keywords provided
JEL Codes: F3; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Interest rate differentials (E43) | excess returns (D46) |
| Nominal interest rates near zero lower bound (E43) | interest rate differentials (E43) |
| Year-on-year inflation rate differentials (E31) | excess returns (D46) |
| Inflation targeting shift in central banks (E52) | year-on-year inflation rate differentials (E31) |
| Inflation differentials (E31) | excess returns (post-zero lower bound) (E49) |