To Raise, or Not to Raise? Central Banks' Interest Rate Conundrum Affects Exchange Rates

Nearly a decade after the crisis, interest rates are still at historic lows,² but the dollar's trade weighted exchange rate has now risen far above the heights it reached in 2008.³ The International Monetary Fund (IMF) warns that the U.S. dollar is 10-15 percent overvalued relative to the fundamentals of the U.S. economy, and this is helping to drive the U.S. trade deficit.

The Dollar's Exchange Rate Creates a Dilemma for the Fed

Since the beginning of 2017 the Fed has been signaling that interest rates will continue to rise, and that it will start to reduce the size of its balance sheet, which has ballooned due to asset purchases from successive QE programs. But if it continues to raise interest rates, the dollar's exchange rate is likely to rise even more, encouraging imports and hampering exports, potentially widening the trade deficit still more.

Inflation is problematic, too. The Fed's dual mandate means that it should give as much weight to inflation expectations as it does to unemployment statistics. The "Phillips curve," which for some decades now has been used to inform monetary policy decision-making, says that there is a trade-off between inflation and unemployment. As unemployment falls and growth increases, there is a risk that low interest rates could cause an economy to overheat and inflation to rise. The trick is to set interest rates so as to keep unemployment at its "non-inflation accelerating rate" (NAIRU),⁴ sometimes called the "natural unemployment rate."⁵ Unemployment is now below the estimated natural unemployment rate, which would seem to justify interest rate rises. But "core" inflation (the Fed's preferred measure) remains well below the Fed's 2 percent target.⁶ Raising rates could push inflation down still further.

However, maintaining low interest rates is not without its problems. For example, very low interest rates make it difficult for banks to build the capital they need to support productive lending. Banks rely for their profits on charging more to lend than they pay to borrow. When interest rates are very low, banks cannot maintain this "net interest margin" unless they impose negative interest rates on borrowers. Borrowers are understandably reluctant to pay banks to look after their money, and so far, banks have proved reluctant to charge them. But as very low interest rates continue for far longer than anyone expected, some banks are beginning to impose negative interest rates on certain types of borrower. As discussed before, negative interest rates can have unintended economic consequences that are not necessarily positive.

Thus, the decision-making Federal Open Marketing Committee (FOMC) is, perhaps understandably, divided on when and how quickly to raise interest rates and unwind QE.

European Central Banks Face a Similar Exchange Rate Dilemma

The European Central Bank (ECB) has committed to continuing asset purchases until December 2017, but the picture beyond that is unclear.⁷ The Eurozone is staging a recovery, with GDP growth improving and unemployment falling.⁸ Additionally, the bloc is running a significant trade surplus, which some have interpreted as indicating that the euro exchange rate is undervalued, suggesting that the ECB should tighten monetary policy.⁹ But the euro's trade weighted exchange rate is rising due to investor expectations of improved growth, and the trade surplus is consequently already falling.¹⁰ And although unemployment is gradually decreasing, it is still high compared to countries such as the U.S. and U.K.¹¹ Meanwhile, inflation remains stubbornly below the ECB's 2 percent target.¹²

Like the FOMC, the ECB's decision makers are divided. Speaking at the Economics Festival in Lindau, Germany, the President of the ECB warned against kneejerk reactions to economic indicators. Quoting John Maynard Keynes's famous remark "When the facts change, I change my mind. What do you do, sir?," Mario Draghi observed that for policymakers, it is not necessarily that simple. "Research helps us to decide whether a change in the facts deserves a policy response or, as we say, we should look through it," he said.¹³ But the head of Germany's Bundesbank, one of the Eurosystem's national central banks, wants asset purchases to end soon, though not overnight.¹⁴

Across the Channel, the U.K.'s economy has performed better than expected in the last year, raising expectations that the Bank of England could reverse the 0.25 percent interest rate cut imposed in August 2016, and perhaps taper off its current QE program.¹⁵