Cheap talk and the exchange rate

Why does the Loonie appreciate when the Bank of Canada tightens monetary policy (relative to what was expected)? And depreciate when the Bank loosens monetary policy (relative to what was expected)?

Before you conclude I've lost it, by asking such an easy question, consider the following weird thought-experiment.

Suppose that one night, just before a Fixed Announcement Date, a determined bunch of inflation hawks sneaks past the security guards, and takes control of the Bank of Canada. The following morning the newspapers report what has happened, and report that the Hawks have raised the overnight rate by 1%. This was a totally unexpected event.

But the newspapers also report that the Hawks don't have enough food to last them till the next FAD, so the real Monetary Policy Committee will set monetary policy at the next FAD. And security has been tightened, so this can never happen again.

So, what happens to the exchange rate?

I don't know the answer. I think it depends on parameter values. But I think it's entirely possible, even likely, that the Loonie will depreciate on the news, despite the (temporary) tightening of monetary policy.

Here's why I believe that.

Suppose (counterfactually, because they won't) the exchange rate stayed the same, and that expected future settings of the overnight rate were not affected by the Hawks' temporary takeover. Then aggregate demand would weaken because of the 1% rise in short-term interest rates, and smaller than 1% rise in long-term interest rates. AD might not weaken much, but it would weaken, and this would cause output and employment to weaken, and inflation to fall below the bank's 2% target. To bring inflation back to target, it would not be enough for the Bank to reverse the Hawks' 1% hike in the overnight rate; it would need to loosen monetary policy by more than this.

So the Hawks' temporary takeover would raise the current overnight rate, but would lower the expected future overnight rate. The lower expected future overnight rate will mean a lower expected future exchange rate. The current exchange rate will be hit by two forces pushing in different directions: the increase in the current overnight rate will cause it to appreciate; the decrease in the expected future exchange rate will cause it to depreciate. It's not obvious (to me) which force will be stronger. Given a high enough degree of momentum in the economy, so it takes a stronger force to reverse than to initiate a disinflationary impulse, I think it quite likely that the Hawks' temporary tightening of monetary policy could cause the Loonie to depreciate.

So if a surprise tightening by the Bank of Canada always causes an appreciation, but a surprise tightening by the Hawks might cause a depreciation, what's the difference? In both cases the long term inflation target stays the same 2%, so neither amounts to a change in the long-run monetary regime. The difference is that when the Bank does a surprise tightening, people believe that a tightening was needed; they revise their beliefs about how strong AD is relative to AS, and so revise their beliefs about the levels of the exchange rate and interest rate that are needed to keep inflation on target.

If the Bank of Canada announced a surprise 1% increase in the overnight rate, and people were convinced that the Bank was just plain wrong, and would soon learn that it was wrong, it would be just the same is if the Hawks had made the 1% hike.

If a respected weather forecaster says you need to carry an umbrella, you carry one. If a pessimist who always carries an umbrella says you need to carry an umbrella, you don't. If the Bank of Canada is a respected economic forecaster, its actions will signal its beliefs, and change expectations and move the exchange rate in a very different way than the Hawks' temporary takeover.

When the Bank of Canada speaks, it might be announcing a current action. It might be making a commitment to a future action. Or it might merely be making a forecast about the future levels of the exchange rate that it thinks will be consistent with the 2% inflation target. (And there is a difference between a commitment to do something in the future and a forecast that you will choose to do something in the future.)

The Bank of Canada did nothing unexpected at its last FAD. It didn't commit to doing anything unexpected either. But it said that it thought the exchange rate was too high, relative to the other forces affecting AD. Those words can matter. Not saying them would have mattered even more, if people expected the Bank to say the Loonie was too high.

But were those words unexpected enough to cause the Loonie to drop by 2% Tuesday morning against the US dollar and the Euro? Then recover it all before dropping back again? Dunno. Like Stephen, I can't make sense of the forex market sometimes. The intraday oil price blip doesn't seem big enough to explain it.

Seems like a long time since I posted anything, or even commented. Just as well Stephen's more than made up for it. I'm recovering from a bad cold, that sapped my energy, morale, and left me feeling generally stupid. Every time I thought of writing something, I read someone else's brilliant blog posts and felt even stupider by comparison. Still not sure this post is up to snuff, but I've got to get back in the saddle sometime.

Comments

[Stephen Gordon]

Welcome back!

[Jon]

I invest in the forex markets, and I pursue a carry trade strategy--going long in relatively high-overnight-rate currencies and partially funding that by shorting low-overnight-rate currencies.

I fail to see a connection to AD or a sense of what it signals, and I am not alone. The forex markets markets are dominated by people like me. We couldn't give one wit about AD. The CB wants to give us money, great. For this reason, wide-spread knowledge of the carry-trade has failed to stem its profitability. Its the CBs that keep losing by their perpetual open-market activities that sustain the arbitrage opportunity.

[Mark]

Your umbrella analogy is spot on.

The Bank's haphazard attempts to jawbone the dollar down are percieved as nothing more. No one seriously thinks the Bank has the ability to lower the dollar, though (as Stephen noted) they can. Even if people accepted that they could, and they wanted to, there is also the perception that the Bank will be unsuccessful.

This Bank is afraid of it's own shadow, and everyone (especially the forex traders) know it. I think Jim Stanford (I know I know...) recently wrote that the loonie would drop 20 per cent the day after the government appointed him Governor of the Bank.

[Nick Rowe]

Thanks Stephen!

Jon: But when you do the "carry trade", don't you worry that the exchange rate will tend to move against you? And don't you worry that changes in AD might matter because they affect the exchange rate?

Mark: If Jim Stanford were appointed Governor, and permanently, that would be different from the Hawks' temporary takeover. First, obviously, because Jim is a dove, and the Hawks are hawks, so they are moving in different directions. But second, and less obviously, because if Jim stayed there he would presumably change the inflation target from 2% to higher (or try to target low unemployment). That would definitely cause a depreciation of the Loonie.

But if I am right, then paradoxically, a temporary takeover by Jim might cause the Loonie to appreciate!

[Jon]

That is not my experience. Many CBs issue sterilization bonds to regulate the movements of exchange-rates despite the pressures of the carry-trade and relative inflation-rates. The primary source of risk arises from panic volatility. Exchange-stabilization of sudden and severe moves is often too late. You've already lost your shirt.