Inflation expectation, monetary policy credibility, and exchange rates

Based on the affine term structure model, we estimate the expected inflation and measure the credibility of monetary policy in order to examine exchange rate dynamics. We find that when the U.S. inflation is expected to be high or corresponding U.K. variable is expected to be low, we can forecast dollar appreciation in the subsequent period. Moreover, the lower the credibility in the U.S. is, the more the dollar appreciates, especially before the 2008 global financial crisis. These findings support the view that exchange rate is systematically affected by the monetary policy in terms of expectation.