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Exchange Rates React to Fed and Bank of England Interest Rate Decisions

By Frances Coppola

On November 2, 2017, the Bank of England (BoE) raised its base lending rate for the first time in over a decade. The increase was small – only 0.25 percent – but it was widely greeted as an historic move. Many expected sterling's exchange rate would rise in response. But instead, sterling's exchange rate fell against both the U.S. dollar and the euro, reaching $1.3063 and €1.1204, respectively.1

A day earlier, the Federal Reserve decided not to increase interest rates. The dollar's exchange rate fell slightly on the news.2 Many analysts then anticipated the Fed's next rate increase, which took place in December 2017.3

 

Economic Theory: Rising Interest Rates Should Cause Exchange Rates to Rise

 

When central banks raise their policy rates – the Fed Funds rate in the U.S. and the base rate in the U.K. – interest rates on other assets denominated in that currency usually also rise. For example, when the BoE raises its base rate, yields on U.K. government bonds ("gilts") and on sterling corporate bonds typically rise. Similarly, when the Fed raises the Fed Funds rate, yields on U.S. Treasuries and dollar-denominated corporate bonds rise. The higher interest rate attracts investors, increasing demand for the currency. This raises the exchange rate versus currencies of countries with lower interest rates.

 

Exchange rates also tend to rise when investors expect interest rates to rise, whether because the central bank is signaling an intention to raise rates or end quantitative easing (QE), or simply because investors think that economic conditions justify rate increases. For example, when inflation is rising, many investors expect interest rate increases to calm inflation. Investors may buy currency in advance of expected interest rate increases, so that they are ready to buy assets denominated in the currency. This tends to raise the exchange rate.

 

The Fed has now raised interest rates several times, and U.S. interest rates are consequently now higher than interest rates in the Eurozone, the U.K. and Japan. The Fed is signaling further interest rate rises in December 2017 and in 2018. So, economic theory says that the U.S. dollar's exchange rate should be strong versus sterling, the euro and the yen. Similarly, the fact that the BoE has recently raised interest rates should strengthen sterling's exchange rate versus the euro and the yen, since both the European Central Bank and the Bank of Japan have made it clear that they will not raise interest rates for the foreseeable future.

 

The Behavior of USD and GBP Exchange Rates Under Uncertainty

 

Both USD4 and GBP5 have risen slightly versus the euro since September 2017, which appears to confirm economic theory. But prior to this, both currencies suffered falling exchange rates versus the euro from the beginning of the year, despite widespread expectations of interest rate increases and – in the Fed's case – actual interest rate increases. This appears to contradict economic theory.

 

This apparent inconsistency appears due to uncertainty. Both the Fed and the BoE have signaled that the path of their respective interest rates will be conditioned on certain aspects of economic performance. The Fed is particularly concerned with the behavior of inflation and unemployment, while the BoE takes into account the economic objectives of the U.K. government as well as inflation. In both countries, there are puzzles and challenges concerning primary economic indicators.

 

The Fed's Inflation Puzzle

 

The Fed's problem is inflation. Core inflation in the U.S. remains below target. The Fed says that inflation will remain low for a while, but it expects inflation to return to the 2 percent target "in the medium-term."6 But in a recent press conference, the Chairman of the Federal Reserve, Janet Yellen, admitted that economists' understanding of the forces driving inflation is "imperfect."7

 

Many analysts expect that there will be an interest rate increase in December 2017.8 But some analysts doubt whether the Fed will be able to raise interest rates as fast as it is signaling, because this could mean inflation remaining well below the Fed's 2 percent target.9 Some economists also express concern that if the Fed goes ahead with interest increases despite inflation remaining below target, this could depress economic growth.10 Conversely, some analysts think the Fed could raise rates faster than expected,11 since the U.S. economy is currently growing at 3 percent per annum,12 unemployment is continuing to fall13 and wage growth is running at between 3-4 percent.14

 

In such an uncertain environment, prudent investors tend to err on the side of caution. Financial markets are therefore anticipating lower interest rates than the Fed is currently signaling. This tends to keep the USD exchange rate weak despite interest rate increases.

 

The Bank of England's Puzzle

 

The Bank of England also has an inflation problem, but in the other direction. U.K. consumer price index (CPI) inflation is currently running above the Bank's 2 percent target. This is mostly due to the considerable fall in sterling's exchange rate since early 2016.15

 

Economic theory says that inflation due to exchange rate depreciation is short-term. A central bank may therefore ignore exchange rate changes when determining the right interest rate setting to achieve the inflation target in the medium term. In its Inflation Report, the Bank said that it expected inflation to fall back to target in the medium term.16 In its statement, the Monetary Policy Committee (MPC) cited a tightening labor market as reason to raise interest rates. However, the MPC warned that there were considerable risks to the economic outlook, and further interest rises were by no means certain.17 The U.K.'s economy is currently growing at below 2 percent per annum, and the BoE's forecast shows no improvement by 2019, although unemployment is expected to remain low.18

 

Investors concerned by the MPC's warning sold GBP when the interest rate increase was announced, causing a sharp drop in sterling's exchange rate.19 Some analysts even wondered whether, with such an uncertain outlook, the interest rate increase was a mistake. However, others thought that the economy's performance could surprise on the upside, especially if wage growth improves.20

 

The

Takeaway:

Responses of the GBP and USD exchange rates to recent interest rate decisions by the Fed and the BoE highlights the difficulty that policymakers face when making monetary policy decisions under uncertainty. Businesses face similar difficulty in an uncertain economic environment: like central banks, they may wish to "monitor closely" developments in inflation, unemployment and economic growth.

Frances Coppola - The Author

The Author

Frances Coppola

With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.

Sources

1. “UK interest rates: Pound sterling falls after Bank of England raises rate for first time in a decade,” Independent; http://www.independent.co.uk/news/business/news/uk-interest-rates-latest-updates-rise-bank-of-england-pound-sterling-falls-a8033376.html
2. “U.S. dollar trade weighted index,” FRED Economic Data; https://fred.stlouisfed.org/series/DTWEXB
3. “US Dollar: A Fed Hike in December is now a given, but it’s in the price,” Pound Sterling Live; https://www.poundsterlinglive.com/usd/7901-us-dollar-the-devil-will-be-in-the-detail-of-november-s-fomc-statement
4. “EURUSD,” Bloomberg; https://www.bloomberg.com/quote/EURUSD:CUR
5. “EURGBP,” Bloomberg; https://www.bloomberg.com/quote/EURGBP:CUR
6. “Federal Reserve Press Release, November 1, 2017,” Board of Governors of the Federal Reserve System; https://www.federalreserve.gov/monetarypolicy/files/monetary20171101a1.pdf
7. “Yellen on understanding of inflation,” The Wall Street Journal; https://www.wsj.com/livecoverage/federal-reserve-september-2017/card/1505932736
8. “US Dollar: A Fed Hike in December is now a given, but it’s in the price,” Pound Sterling Live; https://www.poundsterlinglive.com/usd/7901-us-dollar-the-devil-will-be-in-the-detail-of-november-s-fomc-statement
9. “Traders see next Fed rate hike in mid-2018,” Reuters; https://uk.reuters.com/article/us-usa-fed-futures/traders-see-next-fed-rate-hike-in-mid-2018-idUKKCN1BC50W
10. “Fed’s Kashkari prefers no more rate hikes until inflation hits 2 percent,” Marketwatch; https://www.marketwatch.com/story/feds-kashkari-prefers-no-more-rate-hikes-until-inflation-hits-2-target-2017-10-02
11. “U.S. economy grows 3 percent for second straight quarter,” Financial Times; https://www.ft.com/content/40937744-bb35-11e7-8c12-5661783e5589
12. “U.S. GDP, annual percentage rate of change,” FRED Economic Data; https://fred.stlouisfed.org/series/GDP
13. “U.S. civilian unemployment rate,” FRED Economic Data; https://fred.stlouisfed.org/series/UNRATE
14. “Wage Growth Tracker,” Federal Reserve Bank of Atlanta; https://www.frbatlanta.org/chcs/wage-growth-tracker.aspx?panel=1
15. Inflation Report November 2017, Bank of England; http://www.bankofengland.co.uk/publications/Documents/inflationreport/2017/nov.pdf
16. Ibid.
17. Monetary policy summary and minutes of the Monetary Policy Committee meeting ending on 1 November 2017, Bank of England; http://www.bankofengland.co.uk/publications/minutes/Documents/mpc/pdf/2017/nov.pdf
18. Inflation Report November 2017, Bank of England; http://www.bankofengland.co.uk/publications/Documents/inflationreport/2017/nov.pdf
19. “Interest rates rise but pound plunges as Bank says it’s in ‘no hurry’ to raise them again,” Telegraph; http://www.telegraph.co.uk/business/2017/11/02/markets-await-first-bank-england-interest-rate-rise-decade/
20. “Market reaction suggests BoE policy has entered a holding pattern,” Financial Times; https://www.ft.com/content/60b39460-bfe9-11e7-b8a3-38a6e068f464

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