Bond premia, monetary policy and exchange rate dynamics

DP2016/11 Bond premia, monetary policy and exchange rate dynamics

Anella Munro

Summary

The risk-free interest rate means different things to different people. One notion of the risk-free rate is the return on a bond that has no risk of default, such as a short-term government bill. Another is the unobserved discount rate, that is used to allocate consumption over time. To observe the latter, we would need a bond that paid off in units of consumption. Observed interest rates should compensate the holder of the bond for delaying consumption, for expected losses, in units of consumption value, and for consumption risk. Consumption risk premia compensate the holder for consumption volatility. An asset that performs poorly in bad times should pay a yield above the risk-free rate, because holding such an asset makes consumption more volatile.

This paper sets out an exchange rate model that incorporates (i) a wedge between observed short-term interest rates and the underlying discount rate -a short-term bond premium, and (ii) monetary policy. The model helps to explain three empirical regularities: the disconnect between exchange rates and interest rate fundamentals; the disconnect between measures of risk that price bonds and measures of risk that price currencies; and why exchange rates are less volatile than discount rates implied by equity premiums. The intuition is, respectively: currencies do not respond to the bond premium component of interest rates when the premium compensates the holder for risk; bond risk can be reflected in the bond yield or in the currency, but not in both; and monetary policy stabilisation of the observed interest rate isolates the currency from variation in the underlying discount rate.

In the model with risk, monetary policy can move the underlying discount rate or the short-term bond market premium. Under standard assumptions, the exchange rate response to a monetary tightening looks the same in either case (the currency initially appreciates sharply as in Dornbusch, 1976), and then depreciates gradually to offset the higher risk-adjusted interest payoff, period by period). However, if exchange rates do not fully adjust without capital flows, then adjustment may involve the building and shedding of risk, with implications for international spillovers.

In the model with risk, monetary policy affects the exchange rate in two other ways. Stabilising interest rates between monetary policy decisions (i) isolates the currency from variation in the discount rate, which we think is very volatile; and (ii) shifts the expression of bond risk from bond yields to the currency premium. These trade-offs provide a risk-based interpretation of the monetary policy trilemma.

The paper is available for download at

http://www.rbnz.govt.nz/research-and-publications/discussion-papers/2016/dp2016-11

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