Exchange Rate Disconnect Revisited
We find that variation in expected U.S. productivity explains over half of U.S. dollar/G7 exchange rate fluctuations. Both correctly-anticipated changes in productivity and expectational noise, which influences the expectation of productivity but not its eventual realization, have large effects. This “noisy news” is primarily related to medium-to-long-run TFP growth, and transmits to the exchange rate by causing significant deviations from uncovered interest parity. Together, these disturbances generate many well-known exchange puzzles, including predictable excess returns, low Backus-Smith correlations, and excess volatility. Our findings suggest these puzzles have a common origin, linked to productivity expectations.
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