Systematic monetary policy and the forward premium puzzle

BIS Working Papers No 396
December 2012

Is systematic monetary policy a driver of the forward premium puzzle, i.e. the tendency of high interest-rate currencies to appreciate, thus strongly violating Uncovered Interest Parity (UIP)? We address this question by studying a battery of monetary policy rules in a small open economy that is subject to stationary but persistent domestic and foreign shocks. Each rule leads to model-implied UIP violations, which we derive analytically and then calibrate numerically. Our key finding is that only a forward-looking rule based on CPI inflation can account for frequently observed strong UIP violations.

JEL classification: E52, E58, F33

Keywords: monetary policy rules, uncovered interest parity, exchange rate dynamics, inflation-targeting