The global economic direction has been toward a tightening monetary policy during 2022 to curb surging prices that were not seen since the global financial crisis. But a question pops up here: How does a country's interest rate increase affect its currency?
Increasing interest rates is a tool for monetary tightening (Also called Quantitative tightening (QT)). Interest rates refer to the cost of borrowing money. Real and nominal interest rates are the two different types of interest rates. While the real interest rate is adjusted for inflation, the nominal interest rate does not, representing the true cost of borrowing. Investors regularly monitor interest rates because they have an impact on both micro and macro levels. Therefore, any change in the interest rate will automatically affect the exchange rate of the currency (the value of a currency relative to others); hence, influencing inflation.
An economy with higher interest rates incentives investors to save as a result of the higher returns drawing more foreign investment; thus, the currency appreciates. However, the effect of higher interest rates is reduced if inflation in the nation is significantly higher than in other nations, holding other things constant. While lower interest rates tend to decrease exchange rates. This relationship is referred to as the forward premium puzzle.
A higher value of a currency relative to others reflects a higher demand and thus a high economic activity. However, it is important to note that a higher exchange rate of a currency relative to others does not necessarily mean a better economy. It depends on the state’s policy, a country might decide to control the appreciation of its currency in order to have a comparative advantage relative to others in terms of trade. A less expensive currency means less expensive goods and services, hence, a higher number of tourists and FDIs which in turn will accelerate economic growth. Consequently, with the increase in interest in the country, expectations of the appreciation of the currency increase causing an actual rebound in the currency’s exchange rate, and vice versa.
A real-life example could be the effect of the 7 consecutive rate hikes by the FED on the USD index (figure 1)
Figure 1: USD Index (1W) Vs. FED Funds Rate, source: TradingView (2023)
To sum up, a wise investor/ forex trader is invited to closely watch interest rate hikes as he might be able to take advantage of interest rate differences among countries.
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