Monetary policy in the United States (US) has an outsized impact on the exchange rates of emerging markets in Asia and elsewhere. In light of growing uncertainty about US monetary policy, an interesting question is whether such uncertainty also affects emerging-market currencies. Recent ADB research suggests that US monetary policy uncertainty affects the volatility rather than the value of emerging-market currencies.
The currency turmoil of mid-2018—when countries like Turkey and Argentina saw large currency depreciations in an environment where the US Federal Reserve had been steadily tightening since 2017—underlined the role that US monetary policy can play in shaping emerging-market exchange rate behavior.
In light of slowing US and global growth, the future trajectory of US monetary policy is increasingly uncertain. An unexpectedly strong performance by the US economy in the first quarter of 2019 is exacerbating the uncertainty. The Fed is expected to take a more cautious and gradual approach to monetary policy normalization, but how cautious and how gradual is a subject of much debate.
Uncertainty about US interest rates may affect the value of emerging-market currencies. Systematic analysis of news reports confirm that the public is increasingly unclear about the exact trajectory of US monetary policy.
Recent research finds that searching for relevant text in news articles can deliver useful information on uncertainty about economic policy. A 2016 study constructed a news-based index of US monetary policy uncertainty that attempts to capture the degree of uncertainty that the public perceives about the Fed’s actions and their effects. Currently, the index remains elevated, most likely reflecting the uncertain effect of global trade tensions and the global growth slowdown on the Fed’s policy calculus.
The 2016 study found large spikes of uncertainty connected to major news events, such as Black Monday in October 1987, the September 11 attacks, the March 2003 invasion of Iraq, the collapse of the Lehman brothers in September 2008, Brexit, the November 2016 elections, and other major events. The level of uncertainty seems to be gradually picking up more recently, given the ongoing trade tensions.
We have examined the effect of uncertainty about the US Fed's monetary policy on exchange rate fluctuations in 10 Asian countries, spanning monthly data from 2006 to 2019. The analysis combined the news-based measure of monetary policy uncertainty with a measure of actual exchange rates and the interest rate spread using a country-specific model of exchange rate returns and volatility. The use of this framework identified the impact of monetary policy uncertainty on both the level and variance of return in exchange rates.
The empirical results indicate that uncertainty about US monetary policy affects the variability but not the value of Asian currencies. Intuitively, more uncertainty about the path of US interest rates leads to greater diversity of beliefs about exchange rates among foreign exchange market participants. More diverse beliefs mean more diverse trading and hence more volatile exchange rates.
Our analysis suggests that periods of heightened uncertainty about US monetary policy tend to be periods of heightened volatility in the exchange rates of Asian countries. This strengthens the case for more closely monitoring exchange rates when there is less clarity about the Fed’s course of action.
Although in and of itself the heightened volatility strengthens the case for exchange rate stabilization measures, a great deal of caution is needed since US monetary policy uncertainty is just one of many factors that affect a country’s exchange rate.
This blog is based on the Asian Development Outlook 2019.