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A Reconsideration of the Failure of Uncovered Interest Parity for the US Dollar

In: NBER International Seminar on Macroeconomics 2021

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  • Charles Engel
  • Ekaterina Kazakova
  • Mengqi Wang
  • Nan Xiang
Abstract
We reexamine the time-series evidence on uncovered interest rate parity for the U.S. dollar versus major currencies at short-, medium- and long-horizons. The evidence that interest rate differentials predict foreign exchange returns is not stable over time and disappears altogether when interest rates are near the zero-lower bound. However, we find that year-on-year inflation rate differentials predict excess returns – when the U.S. y.o.y. inflation rate is relatively high, subsequent returns on U.S. deposits tend to be high. We interpret this as consistent with the hypothesis that markets underreact initially to predictable changes in future monetary policy. The predictive power of y.o.y. inflation begins in the mid-1980s when central banks began to target inflation consistently and continues in the post-ZLB period when interest rates lose their primacy as a policy instrument. We attempt to address some econometric problems that might bias the conventional Fama (1984) test.
(This abstract was borrowed from another version of this item.)

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  • Charles Engel & Ekaterina Kazakova & Mengqi Wang & Nan Xiang, 2021. "A Reconsideration of the Failure of Uncovered Interest Parity for the US Dollar," NBER Chapters, in: NBER International Seminar on Macroeconomics 2021, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberch:14593
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    Cited by:

    1. Constantin Bürgi & Mengdi Song, 2024. "Do Professional Forecasters Follow Uncovered Interest Rate Parity?," CESifo Working Paper Series 11338, CESifo.
    2. Albagli, Elias & Ceballos, Luis & Claro, Sebastian & Romero, Damian, 2024. "UIP deviations: Insights from event studies," Journal of International Economics, Elsevier, vol. 148(C).
    3. Michael B. Devereux & Charles Engel & Steve Pak Yeung Wu, 2023. "Collateral Advantage: Exchange Rates, Capital Flows and Global Cycles," NBER Working Papers 31164, National Bureau of Economic Research, Inc.
    4. Gian Maria Tomat, 2024. "The monetary policy trilemma from the perspective of European integration," Economic Notes, Banca Monte dei Paschi di Siena SpA, vol. 53(1), February.
    5. Dobronravova, E. & Trunin, P., 2024. "International monetary policy transmission in EAEU countries," Journal of the New Economic Association, New Economic Association, vol. 62(1), pages 219-228.
    6. Paolo Manasse & Graziano Moramarco & Giulio Trigilia, 2024. "Exchange rates and political uncertainty: the Brexit case," Economica, London School of Economics and Political Science, vol. 91(362), pages 621-652, April.
    7. Rubaszek, Michał & Beckmann, Joscha & Ca' Zorzi, Michele & Kwas, Marek, 2022. "Boosting carry with equilibrium exchange rate estimates," Working Paper Series 2731, European Central Bank.
    8. Marek A. Dąbrowski & Jakub Janus, 2024. "Does the Interest Parity Puzzle Hold for Central and Eastern European Economies?," Open Economies Review, Springer, vol. 35(3), pages 421-456, July.
    9. Gole, Purva & Perego, Erica & Turcu, Camelia, 2024. "UIP deviations in times of uncertainty: Not all countries behave alike," Economics Letters, Elsevier, vol. 242(C).
    10. Vania Stavrakeva & Jenny Tang, 2024. "Explaining the Great Moderation Exchange Rate Volatility Puzzle," Working Papers 24-9, Federal Reserve Bank of Boston.
    11. Dalgic, Husnu & Ozhan, Galip Kemal, 2024. "Business Cycle Insurance, Inflation and Currency Returns," VfS Annual Conference 2024 (Berlin): Upcoming Labor Market Challenges 302436, Verein für Socialpolitik / German Economic Association.
    12. Fan, Zhenzhen & Paseka, Alexander & Qi, Zhen & Zhang, Qi, 2022. "Currency carry trade: The decline in performance after the 2008 Global Financial Crisis," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 76(C).

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    JEL classification:

    • F3 - International Economics - - International Finance
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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