How National Interest and Inflation Rates Affects Currency Rates
Central banks use their interest rate policies to control inflation rates and at the same time control their local currency. The European Central Bank, the Federal Reserve, the Bank of England and the Bank of Japan as all central banks, set the interest rate they use to lend to the financial markets. This interest rate effects all the national interest rates which building societies, commercial banks and other financial institutions set, as well as influencing prices of government bonds, stocks and shares and of course currency rates particularly the local currency. The key exchange rate which central banks set filters its way through the markets to the consumer and essentially drives how consumers spend their money and how businesses spend their money. The action of the central banks in adjusting interest rates has a very direct effect on a country’s economy.
When a central bank increases interest rates it creates an environment where borrowing money is not very attractive because it is expensive, as loan payments become more costly. At the same time savings interest rates become more attractive and more people start to save money. However, higher interest rates attract investors and so the local currency appreciates against other countries as investors purchase the currency to invest in the countries assets. As the exchange rate gets stronger imports become cheaper but exports become more expensive and the economy becomes deflationary. Higher borrowing costs and higher currency rates could lead to higher inflation rates as the costs of goods and services becomes more costly.
Naturally, the lowering of interest rates creates the opposite effect as borrowing costs are low, stock prices tend to appreciate as do house prices. The exchange rate becomes weaker as investors move their money to areas with higher interest rates. All this increases the wealth of the consumers and exports become more competitive. However, as consumers spend more and exports increase this has an inflationary effect on the economy and might force the central bank to increase the interest rate again.
The spending behavior of consumers tends to filter into output production and employment. This has an effect on the employee’s supply and demand as wage costs are changed. It also impacts expectations of inflation by the people that agree wages and it filters downwards affecting costs and prices. No effect works at the same speed as the other and significant time delays are evident on the effects of an interest rate change on spending and saving habits as well as the exchange rate. Therefore, interest rates are changed on the basis of future inflation forecasts, and not on today’s rate and the exchange rate that follows in its wake.