Using the concepts of purchasing power parity and uncovered interest rate parity, the author tries to understand the drivers of the GBP/USD exchange rate. Apart from inflation, his findings identify capital markets as an additional factor in explaining exchange rate movements and support the widely held belief that the US dollar is the world’s reserve currency.
Tracing the history of the GBP/USD exchange rate after the end of fixed exchange rates in 1973 and after the European Monetary System (EMS) collapse in 1992, the author explores the drivers of movements in the exchange rate, including the US dollar’s perceived special status as the world’s reserve currency. The findings have two important implications with respect to monetary policy. First, inflation, or prices in the goods market, alone cannot explain changes in real exchange rates, and the author’s findings suggest capital markets as an additional explanatory factor. Second, the findings support the widely held belief that the US dollar is the world’s reserve currency, as demonstrated by the weaker role US dollar bond yields serve in restoring market equilibrium.
How Is This Research Useful to Practitioners?
Now more than ever, fund managers are widening their investment universe and investing internationally. Thus, fund managers need to understand drivers of exchange rate movements, with the help of economists and foreign exchange (FX) strategists.
Various empirical studies in the past have found shortcomings of purchasing power parity (PPP) and uncovered interest rate parity (UIP) in terms of explaining exchange rate movements. The author adds to that existing literature and focuses on the GBP/USD exchange rate because of the important trade and investment relationships between the two countries. He incorporates market expectations into the analysis of FX movements, as well as the US dollar’s perceived special status as the world’s reserve currency.
The author’s findings support the US dollar’s status as the world’s reserve currency because investors move toward US assets during a flight to safety. The result of that movement is higher asset prices and subsequently lower yields (for example, lower bond yields), which has implications in terms of asset allocation for investment practitioners. Moreover, the findings can help fixed-income managers understand the relationship among expected inflation, bond prices, and the real exchange rate (RER), as well as how those relationships differ in the United States and the United Kingdom. For example, the author shows that empirical shocks to the RER significantly affect expected inflation in the United Kingdom but not in the United States.
How Did the Author Conduct This Research?
The author combines PPP and UIP relationships using a co-integrated vector autoregressive model to capture both goods and capital market interactions while trying to determine the relationships among bond yields, inflation, the exchange rate, and so on. For empirical analysis, he uses seasonally adjusted monthly data for the United States and the United Kingdom. These data include inflation rates, bond yields, and bilateral nominal and real exchange rates. When extending the model, he also inputs additional macroeconomic variables—each economy’s output gap and a world net oil price increase. The author uses a different model to capture the relationship among inflation, expected inflation, net oil prices, and output.
The sample consists of monthly data from January 1985 to June 2008. His rationale for that range is to avoid major fluctuations in global financial markets. All data sources come from the OECD statistics database.
As fund managers expand their investment universe and invest beyond domestic assets, they need to be aware of the drivers of exchange rate movements. The author does a good job of explaining why some of the traditional exchange rate theories, such as PPP and UIP, do not hold up in terms of explaining exchange rate movements and such other factors as the role of the US dollar’s status as the world’s reserve currency. Future study could add to this research by considering other exchange rate pairings.