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Is this why the FED is increasing interest rates?

Stefano F. Fugazzi (ABC Economics) reports – A recent research by two Federal Reserve Bank of St. Louis economists put into perspective last December’s decision by the Federal Open Market Committee (FOMC) to increase rates for the first time in nearly a decade.

The researchers noted that “starting in the middle of 2014, the U.S. dollar experienced a rapid appreciation. The dollar’s value increased by more than 20 percent within nine months, a quick change relative to its history.”

Are the two events – the appreciation of the US dollar and the subsequent rate hike – somehow connected?

The common belief is that a high-interest-rate currency should appreciate relative to a low-interest-rate currency.

For instance, if the central bank of Country A increases interest rates whilst Country B lowers their base rates, then Country A would provide more attractive returns on savings than in the Country B. On that basis, Country A would attract higher inflows of international capital and consequently appreciate his home currency.

Interestingly, the authors of the research observed that a standard textbook theory called uncovered interest rate parity seems to suggest exactly the opposite: high-interest-rate currencies should depreciate.

Suppose that Country A’s three-month rate is higher than Country B’s. An investor can borrow the money in Country B, buy Country A’s currency and invest the money in a Country A bond, which yields a higher interest rate than Country B’s.

After three months, the investor has to exchange the money denominated in Country A’s currency back to Country  B’s and repay the loan.

The investor would record a profit from the difference in interest rates, plus the positive (or negative) variation in exchange rate over the time-period.

According to the uncovered interest rate parity theory, such strategy – typically called a carry trade* –  yields a nil return as interest rate gains are generally offset by FX losses due to Country A’s currency depreciating against Country B’s.

Is the above notion supported by empirical evidence?

The two FED economists argue that there is no empirical evidence to support this notion as a number of studies suggest that in practice exchange rates are (almost) unpredictable in the short run and that there “is weak evidence that a high-interest-rate currency actually has a tendency to appreciate.”

* Carry trade investors have to move funds from one country to another, exposing their investment to exchange rate risk.

 

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