Here is the argument as presented by CNBC and Bloomberg (and most Central Bankers):
- The exchange rate is plummeting!
- Therefore, we must raise interest rates.
Happily, I can say that I understand the logic (it’s taken me a while). But I feel like I’m in the minority – mainly because there is a whole story between 1 and 2 that gets treated as “assumed knowledge”.
So this post is an explanation (and, in all likelihood, a criticism – but to be honest, as I haven’t gotten to the end yet, I don’t know how it will end).
The Exchange Rate/Interest Rate Theory
Welcome to the world of “interest rate parity”. If you ask an economist what the relationship is between exchange rates and interest rates, you will almost always get this:
Which is unpleasant, because an equation might be a concise expression of a concept, but it requires you to pay attention to ns and is and Ss.
So let me try and explain this by getting drunk:
- You walk into a bar.
- Because you’re a man’s man, you’re partial to both pilsener draught and a few drams of Johnny Black.
- Whisky has an alcohol content of 40%.
- Beer has an alcohol content of 5%.
- If you’re aiming to get to merry, you’d be able to take 8 sips of beer for every sip of whiskey.
- So you could establish some kind of equilibrium exchange rate between the two drinks (either 8 millilitres of beer or one millilitre of whiskey will get you to the same state in the same amount of time).
Then let’s say that someone comes in, and tells you that the beer brewers have decided to up the alcohol content of their beer to 10% (perhaps to keep up with the Stella competition). Now – now you only need to take 4 sips of beer for every sip of whiskey.
What should happen?
Well, assuming that we all just want to get liquored and we don’t really mind how, we’ll all start moving across to the pilsener and drinking less of the Johnny. The price of pilsener would get driven up, and the price of Johnny would sink down. So:
- If you’re a whiskey man, the relative value of your dram has dropped from 8 beer mils per whiskey mil down to 4.
- If you’re a beer man, the relative value of your draught has increased from 0.125 whiskey mils per beer mil up to 0.25.
And in case it’s not clear: the alcohol content is representative of interest rates, and the exchange rate is the point at which you’d be ambivalent between drinking whiskey and drinking beer.
Bringing It Back To Economics
So currencies work in much the same way. Interest rates represent the “price” of the currency (where time is money). And if one country is offering to pay you more for holding theirs, then you’d move across to their currency until the rising cost of that currency (relative to the one you initially hold) makes you ambivalent between the two.
*Isn’t there always one?
Not all drinkers drink to get drunk. Alcohol works differently if you’re ill, or if you’re fit, or if you’re taking antibiotics. Some forms make you more aggressive that others. Gin makes me mellow.
That aside, it’s important to remember that perception is important (if not all-important). And if everyone thinks that the interest rate is important, then it is. Here is the 30 day graph of the exchange rate between the Turkish Lira and the US Dollar:
That sudden spike would be the surprise interest rate increase from 4.5% to 10% (and for an explanation of how changes in interest rate affect you, read this post).
So now you know.
Anonymous February 3, 2014 at 08:27
I just saw something on the news about how miners are going to down tools again and it made me think of this article. My (speculative?) understanding is that part of why the Rand has depreciated over the last year or so is to do with declining investor confidence. So even though the interest rate has been increased, perhaps it’s not going to create an increase in demand for Rands as large as the decrease in demand due to the ongoing strikes and probably ever-declining confidence in the SA economy? I’m sure I’ve oversimplified things but is this at least remotely the sort of thing that’s playing out?Reply
Jayson February 3, 2014 at 10:29
Absolutely – I think that investor confidence is a factor. But I also think that the Fed tapering is more important. After all, we’ve had enough strikes for investors to lack confidence in the past. And while there is always some short-term impact, the long term trends (at least, over the last five years) seem to have had more correlation with the activities of the Federal Reserve and the ECB. At least, that’s the feeling that I get.
But I’m happy to be proven wrong. It’d be nice to know that the movements of the Rand can be influenced by internal politics, rather than SA being left dependent on the sentiments of a group of bankers in Washington.Reply
Caustic Pop February 4, 2014 at 11:20
What people aren’t realizing is that the rand (and many of its EM peers) became drastically over-valued in the first few post-crisis years due to the combination of monetary stimulus in the developed world making relative yield attractive in SA (driving so-called hot money capital inflows) along with surging commodity prices and a China still holding itself together maintaining commodity exporter profile (FX-denominated inflows from trade).
This currency over-valuation created an environment whereby fiscal and monetary policies could be stretched to imprudent degrees of accommodation and be maintained due to the masking of their consequences for a protracted period of time. Eventually, however, consequences did manifest that could no longer be ignored- wide budget and current account deficits and relatively higher inflation appeared while credit-fueled growth petered out and the structural under-performance of exports dampened the FX inflow from trade.
The rand, being a free-floating currency with a central bank too meek to micromanage the exchange rate, has actually been baking in these shortcomings quite efficiently since 2011/12. That’s why we’ve witnessed a steady depreciation over years whereas other EMs (who fiddle with their exchange rates or have erroneously been viewed as more credible) more recently have experienced far greater relative currency depreciations over shorter time spans.
QE tapering and growth issues in China have just been major catalysts for a broader theme of disorderly rebalancing that needs to unfold across the EM space. Rates will need to adjust higher as currency over-valuations are snuffed out and deficits forced to narrow, whether by market processes or policy processes.
“Panics do not destroy capital; they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive works.” – John MillsReply
Anonymous February 6, 2014 at 14:22
I love the blog, and the analogy to the bar. But Jayson, you can’t use ‘whisky’ and ‘whiskey’ interchangeably. You’re talking Scotch, then use whisky!Reply
Jayson February 6, 2014 at 18:33
Apologies! It’s the problem with typing first thing in the morning – the caffeine kickstart doesn’t always kick in fast enough!
I’m going to leave the spelling mistakes as is. I want people to know what we’re talking about 🙂Reply