Exchange Rate Disconnect Revisited
Vito Cormun, Ryan Chahrour, Pierre De Leo, Pablo Guerron, and Rosen Valchev
Abstract:
We find that variation in expected U.S. productivity explains over half of G6 exchange rate fluctuations vis-a-vis the USD. Both correctly-anticipated changes in productivity and expectational “noise,” which influences expectations of productivity but not the actual realization, have significant effects on exchange rates. Together, these two types of disturbances explain many unconditional exchange rate patterns, including predictable excess returns, low Backus-Smith correlations, and excess volatility. Our findings suggest these well-known puzzles have a common empirical origin, which is linked to (expected) productivity. We also discuss how noise in expectations has obscured the relationship between exchange rates and fundamentals in the empirical approaches undertaken in prior work.