changes.5, 6 In particular, we use the decomposition of the actual change into an expected and a surprise
(unexpected) component, as displayed in Kuttner (2001, p. 532). Furthermore, we use an event study
approach and incorporate several control variables that capture the surprise element of US
macroeconomic news and policy developments. The period under study is characterized as a floating
exchange rate regime, thus there is no reason to believe that the Fed changes US monetary policy in
response to same-day or short-term exchange rate movements. Based on this institutional factor, it seems
reasonable to assume that exchange rates are reacting to monetary policy changes, rather than the reverse.
Consistent with standard asset pricing theory applied to exchange rates we find that the expected
component of a monetary policy change has no impact on the exchange rate while the unexpected
component of a tightening (loosening) of US monetary policy is associated with a same-day appreciation
(depreciation) of the USD. By comparing the exchange rate response to news with news decomposed
into a surprise and an expected component, to the exchange rate response to news with news measured
simply by the actual announcement itself (which is the sum of the surprise and the expected component)
we show how failure to disentangle the surprise component from the actual monetary policy change can
lead to an underestimation of the impact of monetary policy or even to a false acceptance of the
hypothesis that monetary policy has no impact on exchange rates.
This is an important result as it implies the need for reexamining past empirical work of asset
price responses to macro news whenever such work merely equate macro announcement with macro
innovation without explicitly taking into account the importance of expectations. Specifically, this result
may suggest a possible explanation for why our findings appear at odds with the findings presented in two
well-known studies by, respectively, Eichenbaum and Evans (1995) and Lewis (1995). These studies do
5 Since the market for Fed funds futures opened in 1988, empirical studies have found the Fed funds futures contract
an extremely useful proxy for market expectations of future monetary policy (see Carlson, McIntire and Thomson,
1995, and Krueger and Kuttner, 1996, for early contributions, as well as Sack, 2002, and Sack, Swanson and
Gurkaynak, 2002 and others).
6 The contributions by Andersen, Bollerslev, Diebold and Vega (2003), Evans and Lyons (2005) and Simpson,
Ramchander and Chaudry (2005) use survey data instead of market based measures for capturing expectations and,
in turn, extracting the surprise component of news.