Does a Big Bazooka Matter? Central Bank Balance-Sheet Policies and Exchange Rates
41 Pages Posted: 27 Nov 2018 Last revised: 21 Feb 2019
Date Written: 2018-11-02
We estimate the effects of quantitative easing (QE) measures by the ECB and the Federal Reserve on the US dollar-euro exchange rate at frequencies and horizons relevant for policymakers. To do so, we derive a theoretically-consistent local projection regression equation from the standard asset pricing formulation of exchange rate determination. We then proxy unobserved QE shocks by future changes in the relative size of central banksâ€™ balance sheets, which we instrument with QE announcements in two-stage least squares regressions in order to account for their endogeneity. We find that QE measures have large and persistent effects on the exchange rate. For example, our estimates imply that the ECBâ€™s APP program which raised the ECBâ€™s balance sheet relative to that of the Federal Reserve by 35 percentage points between September 2014 and the end of 2016 depreciated the euro vis-Ã¡-vis the US dollar by 12%. Regarding transmission channels, we find that a relative QE shock that expands the ECBâ€™s balance sheet relative to that of the Federal Reserve depreciates the US dollar-euro exchange rate by reducing euro-dollar short-term money market rate differentials, by widening the cross-currency basis and by eliciting adjustments in currency risk premia. Changes in the expectations about the future monetary policy stance, reflecting the â€œsignallingâ€� channel of QE, also contribute to the exchange rate response to QE shocks.
Keywords: Quantitative easing, interest rate parity condition, CIP deviations
JEL Classification: E5, F3
Suggested Citation: Suggested Citation