All eyes are focused on the Federal Reserve as ponders a rate increase before year’s end. Recent speeches among the members of the FOMC give strong indications that the Fed is about to raise its policy rate as part of its longer term strategy of returning rates to more “normal” levels. But what about the impact of “normalization” on currencies? The level of a nation’s currency plays a significant rolein influencing the impact of monetary policy . For exporters, a falling currency, for example, is the equivalent of easing monetary conditions, giving the exporter a comparative advantage similar to that of lowering the cost of money.
Interest rate differentials go a long way in explaining exchange movements. Today`s divergence in monetary policies between the US and other major economies is already universally understood and expected. The U.S. economy is expanding, albeit slowly, while its major competitors, Japan and the EU countries, stagnate. Thus, the interest-rate differential, like the US rate hike itself, should already be priced into currency values.
As expected the Fed hints of a rate increase has already had an appreciable increase in the US dollar index ( Chart 1). The index is a weighted measure of the euro, yen and other currencies including the U.K. pound, Canadian dollar, and Swiss franc. Currently, the index is at the highest level since the 2008 crisis, and it may continue to climb further should the Fed raise the Fed funds rate.
Chart 1U.S. Dollar Index
However, interest rate divergence is not enough to explain why the US dollar index is appreciating so rapidly. While most currencies may be depreciating (Table 1) in response to US monetary tightening, countries have specific conditions which further influence currency movements. It is generally agree that the correlation between monetary policy and currency values are not as strong as once believed. Let`s look at some of these conditions that currently influence currency movements.
Leave A Comment