Will the Secular Decline in Exchange Rate and Inflation Volatility Survive COVID-19?

Over the twenty-first century, and especially since 2014, global exchange rate volatility has been trending downward, notably among the core G3 currencies (dollar, euro, and the yen), and to some extent the G4 (including China). This stability continued through the COVID-19 recession to date—unusual, as exchange volatility generally rises in US recessions. Compared with measures of stock price volatility, exchange rate volatility rivals the lows reached in the heyday of the Bretton Woods system of fixed exchange rates. This paper argues that the core driver is convergence in monetary policy, reflected in a sharp reduction of inflation and short- and especially long-term interest rate differentials. This unprecedented stability, which partially extends to emerging markets, is strongly reinforced by expectations that the zero bound will be significantly binding for advanced economies for years to come. We consider various hypotheses and suggest that the shutdown of monetary volatility is the leading explanation. The concluding part of the paper cautions that systemic economic crises often produce major turning points, so a collapse of this new and extended Bretton Woods II regime cannot be ruled out.