How National Interest Rates Affect Currency Values and Exchange Rates

2022-05-31 09:49 View 45

A country often issues monetary policy impacting national interest rates to achieve specific economic goals. Whether the country is attempting to promote job creation or stem inflation, the country is intentionally manipulating the monetary supply, availability of credit, and cost to borrow money.

As a result, monetary policy changes that impact national interest rates change the value of that country's currency. A residual impact of raising or decreasing interest rates is that country's currency's value will become stronger or weaker, and downstream impacts on global exchange rates occur. Let's take a look at how monetary policy changes currency value and relative currency strength.

Key Takeaways

  • Higher interest rates in a country can increase the value of that country's currency relative to nations offering lower interest rates.
  • Political and economic stability and the demand for a country's goods and services are also prime factors in currency valuation.
  • Analysts often track a country's balance of trade and financial stability to determine the relative strength of a country's currency.
  • Inflation can lead central banks to set higher interest rates to help cool down a hot economy.
  • As the United States emerges from the COVID-19 pandemic, increases to interest rates have strengthened the value of the U.S. Dollar.

The Effect of Interest Rates

Generally, higher interest rates increase the value of a country's currency. Higher interest rates tend to attract foreign investment, increasing the demand for and value of the home country's currency. Conversely, lower interest rates tend to be unattractive for foreign investment and decrease the currency's relative value.

This simple occurrence is complicated by a host of other factors that impact currency value and exchange rates. One of the primary complicating factors is the relationship that exists between higher interest rates and inflation. Central banks often raise interest rates in response to rising inflation in an attempt to cool off an overheating economy. But, if inflation rises too quickly, it can devalue a nation's money quicker than interest rates can compensate savers.

Factors Impacting Interest Rates

A country's monetary policy and actions towards interest rates are often driven by several macroeconomic factors. In addition, public sentiment towards the country, it's government, and its economic standing play an important part as well.

Politics

The recent history of the U.S. clearly illustrates the critical importance of a country's overall perceived political and economic stability in relation to its currency valuations. As the U.S. government and consumer debt rise, interest rates are maintained near zero in an attempt to stimulate the U.S. economy. When the economy recovers and grows, interest rates increase in an attempt to slow inflation.

Economics

Even with historically low-interest rates, the U.S. dollar still enjoys favorable exchange rates compared to the currencies of most other nations. This is partially because the U.S. remains, at least to some extent, in the position of being the reserve currency for much of the world. This is most often measured through a country's gross domestic product (GDP), as GDP growth and currency value often move together. GDP is often used by national central banks when deciding future impacts on interest rates.

Global Trade

Factors such as a country's balance of trade between imports and exports can be a crucial factor in determining currency value as well. That is because greater demand for a country's products means greater demand for the country's currency as well. Analysts often cite a country's balance of trade and net trading position (net import vs. net export) as a signal of that currency's strength.

Financial Stability

The U.S. Dollar is still perceived as a safe haven in an economically uncertain world. This factor—even more so than interest rates, inflation, or other considerations—has proven to be significant for maintaining the relative value of the U.S. Dollar. One opposing force regarding financial stability is a country's level of debt. High levels of debt, while manageable for shorter time periods, eventually lead to higher inflation rates and may ultimately trigger an official devaluation of a country's currency.

Current Interest Rates

During two unscheduled meetings in March 2020, the Federal Reserve voted to reduce the federal funds rate by a total of 1.5%. This reduced the federal funds target rate to between 0% and 0.25%. This action was taken to promote economic activity; with the onset of business closures and looming unemployment filings, the government intervened to make credit easier and less expensive to come by in hopes of stimulating the economy.

As the world emerged from the COVID-19 pandemic, the United States was among the first nations to reveal strong plans to begin increasing interest rates. Largely in response to a quick uptick in inflation, the Federal Reserve began raising rates in March 2022. On May 4, 2022, the Federal Reserve raised the federal funds rate half of a percent to a target range between 0.75% and 1.0%. As of May 2022, the Federal Open Market Committee (FOMC) economic project has the federal funds rate rising to 2.8 in 2023.

With the Federal Reserve raising rates and expected to continue to do so, the U.S. Dollar has been growing stronger. In May 2022, the U.S. Dollar Index (tracked against six other major international currencies) reached a 20-year high. Favorable interest rate differentials compared to other nations and expectations around future tightening monetary policy stand to continue to benefit the U.S. Dollar.

What Happens to the U.S. Dollar When Interest Rates Rise?

When the Federal Reserve raises the federal funds rate, interest rates across the broad fixed income securities market increase as well. These higher yields become more attractive to investors, both domestically
and abroad.

Investors around the world are more likely to sell investments denominated in their own currency in exchange for these U.S. Dollar-denominated fixed-income securities. As a result, demand for the U.S. Dollar increases, and the result is often a stronger exchange rate in favor of the U.S. Dollar.

How Does Inflation Impact the U.S. Dollar?

Inflation tends to devalue a currency, as that currency experiences a deteriorating level of purchasing power during inflationary periods. If a currency is seen as losing purchasing power, it will more likely not be strongly demanded by investors and is more likely to experience unfavorable exchange rates.

In addition, exchange rates are often set on expectations and perceptions of the country’s economy. If highly inflationary periods are a result of government monetary policy to aid in economic stimulus, foreign countries may feel that country’s economy is weak. It is often when combatting inflation is prioritized over combatting unemployment when a currency strengthens.

What Factors Influence the Exchange Rate?

There are several factors that influence exchange rates. If an economy is experiencing inflation, the purchasing power of its currency is declining, making it less favorable. Alternatively, as interest rates rise, a currency often strengthens. Political stability, healthy economies, and low current account trade deficits are also all favorable.

What Factors Make Currencies More Appealing to Investors?

Investors want to have confidence in a nation’s economy, political infrastructure, and government policies. Currencies are more appealing when fixed-income securities offer higher yields in that currency. For this reason, investors prefer currencies tied to nations with higher interest rates as opposed to loosened monetary policies that devalue the currency through an inflated money supply.

Investors also prefer currencies tied to strong economies that are relied upon for global trade that are experiencing growth. This includes nations whose debt is not outpacing annual economic growth, unemployment is stable, and the balance of trade with other nations is favorable.

The Bottom Line

Many factors impact the value of a nation's currency, especially compared to the currency of other nations. One of the more impactful factors is the country's monetary policy. As the country raises or lowers its national interest rates, the value of its currency changes. While this is often done to create immediate at-home impacts on the nation's economy, these changes have a material impact on what the currency is worth and how much it trades for compared to other currencies.

Catetory: Exchange Keyword: currency exchange
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