I performed a brief analysis to see the correlation between European Central Bank (ECB) interest rate change decisions on spot €/$ rate using interest rate parity condition. From BGIE class last year, I knew that central bank interest rate decisions have a direct impact on interest rates on deposits. I wanted to see how well interest rate parity predicts the change in spot rates in response to ECB decisions. To do that, I regressed difference in exchange rates between the day of the announcement and the day before the announcement (Y variable), with the magnitude of change of interest rate increase or decrease (X variable). (Data and regression results can be found in the appendix) I found that p value was not significant at 95% level, giving me p=0.33. Also R2 was very small 0.06. Paul Krugman says, “Like stock prices, exchange rates respond strongly to ‘news’, that is to unexpected economic and political events, and like stock prices, they therefore are very difficult to forecast.” I didn’t control the impact of interest rate decisions by ECB on spot €/$ for changes in expectations, changes in dollar interest rates or any other news that could have impacted the spot exchange rate, so I didn’t expect to find a high correlation. However, it was interesting to see that the coefficient of the X variable was in line with the predictions of interest rate parity, that is an interest rate hike decision by ECB caused the euro to appreciate against the dollar. Menzie Chinn in a recent article compares predictability of exchange rates using different exchange rate models including the interest rate parity model. He finds that interest rate parity models does better than other models when it comes to predicating the direction of the exchange rate move when measured over a long period of time such as 5 years.
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