By Frances Coppola
The Federal Reserve has already raised interest rates once in 2018,2 and its upbeat assessment of the prospects for the U.S. economy has raised expectations that there will be at least three more interest rate rises in 2018.3 The Bank of England's Monetary Policy Committee recently decided to keep rates on hold, but the decision was split: many analysts took this as an indication that interest rates would be raised at the next quarterly meeting, in May 2018.4 In addition, the European Central Bank (ECB) has said it will end its Quantitative Easing (QE) program in 2018, and the Bank of Japan is also considering exit from QE.5
Economic theory says that when a central bank signals an interest rate change, the currency exchange rate should respond. Higher interest rates tend to attract inflows of capital from investors looking for good returns: since investors must buy a currency in order to invest in assets denominated in that currency, higher interest rates tend to be associated with greater demand for the currency, higher FX transaction volumes, and a rising exchange rate. Conversely, lower interest rates tend to encourage capital to migrate elsewhere, reducing demand for the currency, and hence lowering its exchange rate.
For central banks that target inflation, interest rate decisions are primarily driven by the rate of consumer price inflation. Some central banks also take into account other measures such as the unemployment rate, depending on their particular mandate. When inflation rises, the currency exchange rate tends to fall, as investors sell assets denominated in the inflating currency and buy assets denominated in less inflationary currencies. By offering investors a higher return, raising interest rates can help to stabilize a falling currency and help bring inflation under control.
However, rising interest rates also mean higher financing costs for businesses and households, which tends to discourage both investment and consumption spending. Raising interest rates therefore tends to reduce the rate of GDP growth. A country with a strong GDP growth rate might see little negative effect, but when a country's GDP growth is very low, as it has been for many Western countries since the 2008 financial crisis, raising the interest rate prematurely can prevent the economy recovering. Central banks have therefore been very cautious about raising interest rates.
When only one central bank raises interest rates, it can be fairly easy to deduce what the effect might be on its currency exchange rate.
For example, if the Fed is the only central bank raising interest rates, then there could be one of two effects on the USD exchange rate. If investors believe that the U.S. economy is robust enough to absorb the interest rate rises without GDP growth slowing appreciably, then investment in dollar-denominated assets could increase, lifting the dollar exchange rate. However, if investors believe that the pace of interest rate rises threatens to depress economic growth, they could decide to move their money elsewhere, causing the USD exchange rate to fall.
Carry trades can also influence the dollar exchange rate as interest rates rise. If, for example, the Bank of Japan maintains its current very low interest rates while the Fed raises rates, traders may borrow in yen and lend in dollars, which would likely raise the USD/JPY exchange rate.
However, when several central banks simultaneously signal monetary policy tightening, the exchange rate effects are harder to predict. Exchange rates may become more volatile, as market participants try to judge how central banks' decisions interact to affect the global economy.
Although the Fed is ahead of other central banks in the race to raise interest rates, the U.S. dollar is not the strongest currency in the world right now. The euro exchange rate has been rising for some time versus USD, fueled by a growing recovery in the Eurozone and expectations that the ECB would soon end its QE program.6 However, there are signs that the euro is beginning to weaken,7 possibly because of uncertainty about the future path of interest rates.8 Sterling also strengthened versus the U.S. dollar when the Bank of England's split decision was announced.9 And despite continuing slow growth and low inflation in Japan,10 the JPY/USD exchange rate has been rising since the beginning of 2018.11
So far, the USD trade-weighted exchange rate has not risen in response to the Fed's tightening signals, as might have been expected.12 The dollar even weakened after the Fed raised rates on March 21, 2018, apparently because the Fed was "not hawkish enough."13 However, this could change in response to economic conditions, fiscal forecasts, and political decisions in any of the countries involved.
When several central banks are simultaneously tightening policy, exchange rates can move in unexpected directions, and may become more volatile. Investors use measures of the relative strength of the economies concerned and global indicators such as trade figures to help them in their investment decision-making. Businesses, too, may wish to keep an eye on global as well as local economic indicators to help them judge how to calibrate their FX risk management strategies.
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.
1. “What Hawkish and Dovish Mean in Monetary Policy and Trading,” Trading Heroes; https://www.tradingheroes.com/hawkish-and-dovish/
2. “Fed lifts rates and flags extra rises on strong growth,” Financial Times; https://www.ft.com/content/de255f20-2d24-11e8-9b4b-bc4b9f08f381
3. “Analysts still see chance that Fed will change rate outlook for 2018,” Financial Times; https://www.ft.com/content/d15b1468-2d3a-11e8-9b4b-bc4b9f08f381
4. “Bank of England sets the stage for interest rate rise in May,” Financial Times; https://www.ft.com/content/db189320-2dc8-11e8-a34a-7e7563b0b0f4
5. “Bank of Japan governor hints at exit from monetary stimulus,” Financial Times; https://www.ft.com/content/e9cc17e6-1dc1-11e8-aaca-4574d7dabfb6
6. “Eurozone growth reaches highest level in a decade,” Financial Times; https://www.ft.com/content/74b3b8e4-05aa-11e8-9650-9c0ad2d7c5b5
7. “EURUSD,” Bloomberg; https://www.bloomberg.com/quote/EURUSD:CUR
8. “ECB Faces Year Of Living Uncertainly After Conclusion Of QE,” Bloomberg; https://www.bloomberg.com/news/articles/2018-03-21/ecb-faces-year-of-living-uncertainly-after-conclusion-of-qe
9. “Sterling pops higher after BoE decision,” Financial Times; https://www.ft.com/content/74b46dc4-2dc9-11e8-9b4b-bc4b9f08f381
10. “Japan wage increases fall short of Abe’s 3% target,” Financial Times; https://www.ft.com/content/f1f52f2a-275d-11e8-b27e-cc62a39d57a0
11. “JPYUSD,” Bloomberg; https://www.bloomberg.com/quote/JPYUSD:CUR
12. “U.S. dollar index,” Bloomberg; https://www.bloomberg.com/quote/DXY:CUR
13. “US dollar drops after Fed decision,” Financial Times; https://www.ft.com/content/2c110db4-2d35-11e8-9b4b-bc4b9f08f381