EURO-DOLLAR

EXCHANGE RATE
How Quantitative Easing announcements and interest rate changes impacted the value
of the Euro against the U.S. Dollar since 2008

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Broad Trends
By late 2008, the effects of the housing price bubble in 2006 had left financial markets
dysfunctional, leading to the fall of Lehman Brothers and financial crisis across the world. The
Federal Reserve (FED) began to embrace less conventional monetary policies including
Quantitative Easing (QE) to stimulate economic growth, by injecting money through
purchasing substantial quantities of assets with medium and long maturities to drive down
private borrowing rates. In 2009, European Central Bank (ECB) also announced the large-scale
asset purchase to inject money supply into the
economies. By purchasing particular assets, the
FED and ECB reduced the amount of the security
that the private sector held, which rise up the
price of the asset and hence lower its yield
(Fawley & Neely, 2013). FED had carried on QE
programme since 2008 starting with QE1, QE2,
Maturity Extension program and ended QE3 in
October 2014. Meanwhile, The ECB has
announced a QE under the threat of deflation
from March 2015 (ECB, 2015). These
announcements and actions had a significant
Figure 1 - Federal Reserve Bank Assets
influence on EURUSD exchange rate. After the
(Federal Reserve, 2014)
crisis, not only USD has been depreciated against
EUR but also the
volatility of the exchange rate was high. The highest exchange rate in the period from 1/1/2008
- 1/2/2015 was 1.5759 Euro per U.S. Dollar and the lowest exchange rate was
1.1350. The mean of the exchange rate in this period was 1.3561 with a standard deviation of
0.0874.
Macroeconomic Variables Influencing Exchange Rate
In this report, flexible price monetary model (Frenkel, 1987) will be selected to analyse
the effects of QE and interest rates announcements on foreign exchange rate.

Purchasing Power Parity (PPP) and exchange Rate

The flexible price monetary model is essentially an extension of the purchasing power
parity view of exchange rates. PPP is founded on the law of one price, which imply that
identical goods will have the same price without considering transaction cost. The relative
version of this theory is considered more relevant in this case (SP=P). It implies that
inflation differentials should be equal to depreciation rate of the currency of the high inflation
rate country. Under this explanation, more (less) inflation in Europe than in the US will cause
dollar to appreciate (depreciate).
Interest rate and exchange rate
Interest rate is one of the most important factors that influence the exchange rate. Fisher
effect, which is also known as uncovered Interest Parity, connects the interest rate and exchange
rate. Assuming that real interest rates are equal across the countries, the difference of nominal

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interest rates between two currencies determines the movement of their nominal exchange rate.
Specifically, currencies with high nominal interest rate tend to depreciate because of increased
inflation expectation. However, researches, which have attempted to exploit evidence of an
equilibrium based on such an approach, provided different outcomes (Byrne, Nagayasu, 2010)
Real Income, Money Supply and exchange rate
An increase in domestic real income, or reduction in domestic expected inflation, will
raise the demand of domestic currency and therefore causes appreciate (Frenkel, 1987).
However, the announcement of QE does not directly affect the real income. Therefore in this
case, this factor will not be discussed much. The exchange rate, as the relative price of currency,
is determined by the supply and demand for money. QE, essentially as an increase in the supply
of money is likely to cause inflation. This domestic inflation will cause goods relatively less
competitive and export demand will reduce. Therefore, there will be less demand for the
currency and its value will tend to fall on the exchange rate markets.
How announcements impact the exchange rate
According to De Haan and Jansem (2005), analysing the influence of announcements
on exchange rate is best interpreted through the news approach, as the news approach stipulates
that if the currency market is efficient, only unexpected news have an influence on the exchange
rate. Cheung and Chinn (2001) stressed that currency traders believe that the amplitude of the
adjustment takes place even within a very short time after new information is publicized.
Considering the model and timespan of the paper, we will only consider the short-term impact
of the QE and interest rate change announcement. Moreover, news from the U.S. and Europe
must be differentiated to bring a better approximation of their specific impact on the exchange
rate (Ehrmann & Fratzscher, 2005). Ehrmann and Fratzscher (2005) determined that news
about the US economy have a larger impact on the EURUSD exchange rate than news from the
euro area, due to the fact that the U.S. economy is greater but also because U.S. announcements
are released earlier than similar euro area announcements. There are several factors influencing
an exchange rates, however, the FED and ECB only have a direct control over changes in
interest rates Grossman (1981) found there is an important correlation between unforeseen
changes in money supply and changes in interest rates (as cited in Knot, 1996). Interest rates
having a direct influence on both the price stability, it is considered as the most important
monetary tool. Price stability is essential in the perspective of increasing economic welfare and
growth.
Interest rates changes
De Haan and Jansem (2005) remarked that any announcements of changes in interest
rate have been affecting the exchange rate through three channels: investors, inflation and
growth. An announcement of higher interest rates in Europe can make the securities more
attractive, effectively increasing the demand for Euro. Similarly, if the FED would increase in
interest rates and assuming purchasing power parity holds, then it would bring a downward
pressure on inflation, bringing the dollar to appreciate. Relating to growth, a change in interest
rates would negatively correlate to the economic growth, as high interest rates could prevent
further investment to come, which ultimately will impact future economic growth, probably
leading to a weaker currency. There is also a possibility of asymmetric reaction to news from
these two official financial entities. For instance, comments signalling interest rate incline may
cause the exchange rate to alter, while comments specifying lower interest rates do not (De
Haan & Jansem, 2005).

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Money supply levels

Joyce et al, (2011) also determined quantitative easing announcements were affecting
the exchange rate via the portfolio balance channel. A money supply level increase has for
primary effect to lower bond yields as the massive purchase of securities increases prices drives
yields down. As a result, an announcement would trigger reactions from investors who want to
protect their investment. Offsetting these loss would require to have either an appreciation in
the foreign currency the investors is from or a depreciation of the currency the quantitative
easing is. Similarly, unexpected increase in money supply prompts agents to anticipate central
bank to respond by tightening policy to avert money stock from progressing more speedily than
planned. Expecting future monetary curtailment leads to higher real interest rates, agents to bid
hostilely for funds in the spot market and interest rates to rise. This is mainly Keynesian
approach to the variation in rates triggered by the changes in the supply of money (Cornell,
1982).
Announcements of Federal Reserve and European Central Bank

Figure 2 - EURUSD exchange rate (2008 2015) (Reuters, 2015)

Monetary policy has an effect on exchange rates through several channels, particularly
in a short-run through. Because of the disclosure of news regarding the initiation of QE
programmes and Operational Twist by Fed, the actual application of the programmes and the
decreased interest rates, EURUSD exchange rates started fluctuating randomly as seen in
Figure 2.

First round of Quantitative Easing in the U.S.

In August 2007, the Federal Open Market Committee's (FOMC) target for the federal
funds rate was 5.25 %. During the downturn the FOMC decreased the target for the federal
funds rate to nearly zero. Some economists believe that central banks are helpless when shortterm rates are close to zero-bound, others however, claim that prices and output can still be
altered by purchasing long-term assets. FED began pursuing less traditional form of monetary
policy to stimulate economic growth and concentrated on buying two types of assets such as
government debt and assets backed by home loans (Fawley & Neely, 2013). $300 billion in
long-term Treasury bonds was bought in order to stimulate aggressive moves in other markets.
Moreover, $100bln was spent to repurchase MBS and agency debt to

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Figure 3 - FED & ECB Interest Rates (2008 -2015) (Reuters, 2015)

decelerate ever-increasing chaos in the U.S economy. Large-scale asset purchase (LSAP)
announcements by FED reduced U.S long-term yields.
As the first QE by FED was an instant measure to deal with the financial crisis public
was unaware of the whole process before it was introduced. Prior to the announcement of the
first QE EURUSD rate was 1.27 with interest rates being 1%. Straight after the announcement
of QE in the U.S. in November 2008 the exchange rate has decreased only slightly to 1.26
because the process required more time for market to adjust. With the formal application of QE
in December 2008, exchange rate has increased considerably to 1.37 and interest rates were
lowered to 0.25% as seen in Figure 3. This ultimately led the U.S. stock market to recover,
while the dollar to drop against other major currencies. In the bond market, prices of Treasuries
increased, thus decreasing yields by the most enormous amount since 1987 (Marketwatch,
2009). Although, the Fed rapidly started pursuing quantitative easing programmes ECB
adopted measures that were mainly aimed to certify the distribution of liquidity and improving
the bank-lending channel via making changes to its conventional monetary policy
implementation framework (Claeys, 2014). Despite the fact that there was no official QE
initiated by ECB, it has also brought repo rate to a lower level following FED (Apergis et al,
2011). Furthermore, ECB launched covered bond buying programme, which summed for
60bn at the time Greek crisis was determining the propensity of banks to issue covered bonds
and unsecured debt. Eurosystems covered bond purchase programme (CBPP) was also
implemented in 2011 in order to intensify conveyance of monetary policy and sustain
distribution of credit to the European economy (Atsins &Watkins, 2012). In the fourth quarter
of 2008, interest rates in Eurozone were 4.25% compared to 2% in the U.S. Interest rates in the
euro area illustrated high volatility by decreasing to 2.25% at the end of 2008, 2% during the
first month of 2009 and 1% further in mid-2009. Lower rates and increased money supply
motivated households and businesses to spend more thus, enhancing economic activity.
However, despite ever-changing interest rates by ECB by the time first QE in the U.S was over
in April, 2010 EURUSD exchange rate was 1.32, which, was roughly the same (0.5 decimal
points higher) as prior to the QE announcement.

Second round of Quantitative Easing and Operational Twist in the U.S.

Before the announcement of the second QE in November 2010, EURUSD has been
fluctuating around 1.39. This value has decreased right after the announcement to 1.29 and the
interest rates were kept at a constant rate of 0.25%. Second QE initiated in November
2010, lasted 7 months and aimed to purchase US treasuries, spending $85bln each month.

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Unlike the first QE, the second QE was announced well before to the public. Throughout the
second round of QE, interest rate in the U.S were kept at 0.25% while between 0.75-1% in the
euro area. With the conclusion of QE in June 2011, it was considered to be more successful
than the first QE. Furthermore, EURUSD exchange rates were less volatile during this period
with the overall tendency to rise. Following the second QE in mid 2012 Fed initiated
Operational Twist spending $85bln per month, by purchasing MBS limitless. Before
Operational Twist EURUSD rates were 1.43 but with the announcement in September, 2011
rates have decreased by 0,1 decimal points to 1.33. Ultimately, the expansion of Operational
Twist strengthened the dollar and increased the volatility of EURUSD rates with a high
tendency to fall and reach 1.29.

Third round of Quantitative Easing in the U.S.

EURUSD rates were fluctuating around 1.26 before the announcement of the third QE by
the Fed in September 2012. The third QE was planned to continue until either unemployment
falls below 6.5% or inflation rises above 2.5% (Heard, 2013). In a few months, the rate has
slightly increased by 0.3 decimal points to 1.29. With the conclusion of last QE, EURUSD rates
have returned to its pre-announcement level of 1.25 and interest rates of 0.25% in the U.S. and
0.05% in the euro area. At the time the Fed was about to conclude its QE programme in September
2014, the ECB announced two new purchase programmes, namely the ABS purchase programme
(ABSPP) and the third covered bond purchase programme (CBPP3) (ECB, 2015).
European Quantitative Easing Announcement
Overall evaluation of the trend in EURUSD rates shows that the rates have been volatile
and have decreased sharply particularly in the last three quarters. Starting with December 2008
Fed managed to keep its interest rates at a constant 0.25 %. ECB on the other hand was
manipulating interest rates throughout the whole period of 2008-2015. ECBs aggressive
scheme of launching 60bln a month and expanding asset purchase programme might not work
as it still does not guarantee that the inflation will be boosted which is the key problem in the
euro zone as illustrated in Figure 4 (Davis, 2015). With Russias rubble hitting low against
dollar, ECB loosening and FED tightening, dollar is likely to see continued gains and stay as a
major currency (Hilsenrath, 2015). Presumably,
in case of a new wave of economic crisis dollar
will be perceived as safe haven currency again
and be preferred to euro denominated assets. It is
worth believing that, the ECB is committed to
buy sovereign bonds through to September 2016
resulting in the increase of the money supply in
the economies while the Fed has stopped the third
QE since October 2014. It is hoped that the
program will help to boost inflation levels,
increase exports and kick-start growth. However,
there will be no real economic benefit from lower
Figure 4 - Inflation in the Euro Area. (ECB, 2015)
government bond yields because most of them
have already hit the zero bound. Hence, we
expect that the EURUSD is likely to fall since the divergence with the US is set to become
more pronounced over the coming months assuming that there is no increase in Greece
withdrawal from the EU fears.

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