The interest and exchange rates; an ambiguous relationship.

The nature of the relationship is questionable, what really does a change in interest rates in the market mean for the exchange rate and vice versa? Here, I will look at some data and theory to see if we can pick out a link between the two variables, and attempt to explain the vastly complex relationship.

What Interest Rate Are We Talking About? There Are Thousands!

Due to this issue the rate of interest usually used in macroeconomic analysis is the ‘risk free rate’, being that where no premium is required to adjust for risk of default. Usually measured by a 10 year gilt (UK government bond, even now with the state of our economy). There is roughly an equalisation between this rate and rates for basic deposits due to investment arbitrage.

The ‘Risk Free’ Rate is most commonly used, typically a 10 year government bond…..

Describing the Relationship

Interest rates can rise or fall due to various factors, I will list some theoretical and empirical implications of this on the exchange rate, before attempting to define what the relationship actually is….

Purchasing Power Parities and the International Fisher Effect

The noteworthy early 20th century Irving Fisher (who is sadly remembered for his awful predictions leading up to the Great Depression..) created a theory following his original Fisher effect. The first theory, which is evidential, is that real interest rates in an economy remain fairly constant over time, and that interest rates largely depend on inflation via a very simple equation:

Fisher Effect:     Interest Rate=k+Inflation

With K as the constant real interest rate

How Fisher Effect Relates to the International Fisher Effect

States that because exchange rates between two economies are inversely linked with the spread in inflation, and inflation moves with equal step with interest rates, then the spread of interest rates will reveal the relative movement of the two currencies.

Purchasing Power Parities

The concept is simple. For instance, say if I were to change £5 sterling into roughly 50 Yen, then I should be able to buy roughly the same amount in Japan, a few (Eastern mainly) beers in the shop and a kebab, as a fiver would buy in the UK.

Inflation v Exchange Rate(against USD and the old school Franc) for Switzerland….Roughly an Inverse Relationship

PPP ‘disparities’ are stable and change (often converge) slowly. Yes there may be differences in PPP, as factor costs can be cheaper in real terms overseas, notably wages in more rural areas abroad, but whatever disparity there is will be relatively stable and converge very slowly in real terms. So if a fiver in 2011 pounds could actually buy you 4 beers, a kebab and a taxi home this time in Japan with whatever a fiver gives you in Yen, it will take a while before any major change in this occurs.

With this in mind, say the beers and kebab now costs 55 Yen(instead of 50) a year later and £5 still in the UK, it is obvious the Yen has now devalued in what it is intrinsically worth relative to the pound in what it can buy by about 10% and so we expect it to on the forex market.

With interest rates hypothesised to move with equal step with inflation it holds up that interest rate spreads will have the same effect, say, if the Japanese rate had a 10% spread above the UK rate. This is how the theory (supposedly) works…

Impact on Real Interest Rates

Above assumes the real interest rate is constant, but it too is subject to change which can pull the exchange rate the opposite way to what the PPP method would expect, sometimes so much so, the model breaks down as in the first example….

Market Rates and Macroeconomic Confidence

Where higher real interest rates can cause a devaluation…

It is a noted fact that higher interest rates can prevail, at least temporarily, when an economy is entering a liquidity or banking crisis, as it did in September 2008, as lending money be it to banks or businesses is seen as a much higher risk (as obviously, banks start to find their Capital Adequacy Ratios are in fact, inadequate, along with the expectation that business revenues will fall). 

As below, the LIBOR greatly diverged from the base rate, due to a justified lack of confidence in the financial sector after Lehman Brothers collapsed…

It is more the case that financial confidence mentioned above causes the real, rather than the nominal interest rate to change, due to deflation or lower inflation accompanying such a situation. The change in real interest rates must be factored in to the above PPP IFA model. Anyways financial crises=higher rates for the short term anyway and….

We know what happens to the currency of an economy entering a financial crisis

But Don’t Rates Fall in a Crisis? They have done, as we can see above, yes…. But it is worth noting that without a central bank providing mass expansionary monetary policy, interest rates would have stayed higher for longer. It is becuase of the QE and lowered base and libor rate that government bonds have also shown lowered yields.

As the worlds major economies do have central banks, this point has been relegated to obiter.

The Arbritrage Effect; Can Higher Rates Mean Appreciation?

Although with higher interest rates as seen above a currency is likely to devalue, this devaluation may be mitigated by the effect of an inflow of funds to take advantage of the spread between rates, known as a carry trade. This is especially true if the real interest rates are higher too.

Use the idea that total assets under management (AUM) as of 2007 totalled to $74.3 trillion, 1.5 times world GDP! With this fact, it is obvious arbitrage can swing markets wildly independent of any attempted government intervention….Think what investors would do if the risk free interest rate was higher in, say hypothetically, Australia than Russia (where in reality there is no such thing as a ‘risk free rate’).

Assuming no movement yet in the exchange rates for other reasons you can be sure that mucho money will be moved from Rouble into the AUD the take advantage, thus appreciating the AUD to a considerable extent, contrary to the original idea which seemed, at first, common sense.

The Key Difference Between These Two Examples

We have seen above that higher real interest rates, on top of the International Fisher Effect, can cause a devaluation or a relative appreciation of the currency.

Devaluation will take place where the increase in the real interest rate is in a deflationary, panic stricken period, where people have a higher liquidity preference (willingness to hold cash). This can break the model into a million glass pieces…

Appreciation will take place where the increase in real market interest rate accompanies a period of high confidence and rising real asset prices for instance. Less chance of a model breakdown!

The Proposed Relationship

So, we have something fairly tangible…..The changes in an exchange rate between two economies are inversely related to the spreads in the so called ‘risk free’ interest rates, or rather financing arrangements of similar risk if the country is a Greece or a Libya where the term ‘risk free’ seems a little oxymoronic. Even though, for instance, in the early 1980’s Sterling was a lot stronger against the dollar despite around 18% inflation at this time, it is the changes in the relative value given the interest rate spreads, that we are concerned with here, not the absolute values.

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Real Interest Rates May Vary: This change can be mitigated by the arbritrage effect, or, in fact, a financial crisis where the model appears to fall apart (like lots of other supposed models simultaneously) possible causing a wild swing to the opposite of what you would expect. This is because, however, the exchange rate is moving being weighted much more to other factors than just interest rates! These events above also are often accompanied by a change in the real interest rate.

Remember, exchange rates are defined and change over time due to many other factors. It is only the interest rate we are concerned with here. You may wonder, for instance, why the Euro has vastly appreciated against the Pound in the last 5 years despite having relatively higher inflation and interest rates when the UK was in the Great Moderation. It was certainly not due to interest rates, which actually mitigated the change…..

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