Engel (2016) highlights puzzling patterns regarding interest rate differentials and foreign exchange rates: while a high-interest-rate currency tends to earn a positive excess return in the short run, its long-run excess return tends to be negative. We present an explanation of these patterns based on inflation risk premium: whereas short-term interest rates do not affect short-term inflation risk premia (because of price stickiness),,they negatively affect long-term inflation risk premia (because of money neutrality). Different responses of short-term and long-term inflation risk premia generate different patterns of short-term and long-term FX excess returns. We present empirical evidence to support this explanation.

Keywords: Foreign exchange rates; inflation risk premium; price stickiness; money neutrality; uncovered interest parity; purchasing power parity