Permanent and temporary monetary policy shocks and the dynamics of exchange rates

Over the short run contractionary monetary policy shocks tend to be associated with domestic currency appreciations, which goes against standard interest rate parity conditions. How can this be reconciled with the fact that these conditions tend to be restored over the long run? We show the distinction between permanent and temporary monetary policy shocks is helpful to understand the impacts of monetary policy on exchange rates in the short as well as over the long run. Drawing on monthly data for the United States, Germany, France, Great Britain, Japan, Australia, Switzerland and the euro area from 1971 to 2019, and resorting to a simple structural vector error correction (SVEC) model and mild identifying restrictions, we find that a shock leading to a temporary increase in U.S. nominal interest rates leads to a temporary appreciation of the USD against the other currencies, in line with the literature on the exchange rate effects of monetary shocks and that on the forward premium puzzle. In turn, a monetary policy shock leading to a permanent rise in nominal interest rates - e.g. one associated with a normalisation of monetary policy after a long period at the zero lower bound - has the opposite impact, i.e., in line with interest parity conditions, in the short as well as over the long run. The ensuing depreciation may also contribute to higher (not lower) inflation, also in the short run. We thus confirm, in a simpler setting and for more economies, the results of Schmitt-Grohé and Uribe (2021). This highlights the relevance of differentiating between temporary and permanent monetary policy shocks in interpreting short-run exchange rate movements.