A Fundamental Connection: Exchange Rates and Macroeconomic Expectations

Abstract

This paper presents new stylized facts about exchange rates and their relationship with macroeconomic fundamentals. We show that macroeconomic surprises explain a large majority of the variation in nominal exchange rate changes at a quarterly frequency. Using a novel present value decomposition of exchange rate changes that is disciplined with survey forecast data, we show that macroeconomic surprises are also a very important driver of the currency risk premium component and explain about half of its variation. These surprises have even greater explanatory power during economic downturns and periods of financial uncertainty. Emails: vstavrakeva@london.edu, jenny.tang@bos.frb.org. The views expressed in this paper are those of the authors and do not necessarily represent the views of the Federal Reserve Bank of Boston or the Federal Reserve System. Nikhil Rao provided invaluable research assistance on this project. We thank Pierre-Olivier Gourinchas, Hélène Rey, Kenneth Rogoff and the participants at various seminars and conferences for their useful comments.