Interest Rates and Exchange Rates Have a Muddled Relationship
Particularly if you manage a multinational company, anticipating fluctuations in exchange rates can be an extremely important part of your company’s financial management success. So what influences exchange rates?
The International Fisher Effect says that for every 1 percent differential that a nation has in its nominal interest rates over another nation, the currency of that nation will experience a 1 percent decrease in exchange rate via inflationary pressures associated with increased interest, increased consumption, and investment speculation.
For example, if the U.S. has an interest rate of 10 percent and Mexico has an interest rate of 11 percent, then according to the International Fisher Effect, the exchange rate of the Mexican peso would drop by 1 percent relative to the U.S. dollar. This drop occurs because the United States’ relatively lower interest rates will stimulate consumption and capital investment in the nation, causing inflationary pressure to depreciate the value of the currency to both foreign investors and foreign traders.
That being said, the IFE itself is more of a “jumping-off point” meant to prove a point, while more elaborate models based on it have improved accuracy and usefulness.
The International Fisher Effect tends to hold true only in a cluster formation soon after the interest rate differential occurs because a change in interest rates happens only once while exchange rates are in an ongoing state of fluctuation, you end up seeing a J curve when you graph the two rates.
With the J curve, the exchange rate drops at first before rising up higher than the original point, forming a J shape when graphed. This pattern occurs as the exchange rate goes down at first but then goes back up as the lower exchange rate and devalued currency causes a nation’s exports to be relatively cheaper for people in other nations, attracting more trade over the long run.
In addition, many large nations, such as the U.S., have very stable economies. U.S. treasury bills, for instance, are considered “risk–free” investments, and U.S. treasury bonds are considered to be extremely low risk, except in that interest rates may fluctuate, causing the future value of a low-interest bond to decrease.
Even during record government debt, the U.S. Government can still issue bills and bonds that yield next to 0 percent interest without too much trouble because when interest rates rise, the broad market infrastructure and openness to foreign investors maintains high levels of capital investment.
On the other hand, some nations with smaller or more volatile economies lose a significant number of investors with lower interest rates because investors don’t want the additional risk without higher returns. Plus, such nations typically don’t have stable capital investments.
To summarize, the IFE allows corporations to forecast changes in exchange rates and international markets using current interest rate differentials, but they may have to experiment mathematically a bit to make their forecasts accurate enough to be really useful.