By YiLi Chien, Senior Economist, and Paul Morris, Research Analyst
Starting in the middle of 2014, the U.S. dollar experienced a rapid appreciation. The dollar's value increased by more than 20 percent within nine months, a quick change relative to its history. This appreciation corresponds with the lead-up to the Federal Open Market Committee’s first interest rate hike in nearly a decade. Is there any relationship between these two events?
A common story connecting these two events is based on the argument that a high-interest-rate currency should appreciate relative to a low-interest-rate currency. If the Fed raises interest rates while other central banks maintain or even lower their interest rates, then the return on savings is more attractive in the U.S. than in other countries. Given this higher rate in the U.S., international capital should flow from other countries to the U.S., resulting in the dollar's appreciation.
Do the economic theory and data support this story? A standard textbook theory—uncovered interest rate parity—argues exactly the opposite: high-interest-rate currencies should depreciate.
Consider an investment strategy of borrowing in a low-interest-rate currency and investing in bonds denominated in a high-interest-rate currency. This is typically called a carry trade. Carry trade investors have to move funds from one country to another, exposing their investment to exchange rate risk.
For example, suppose the U.S. short-term risk-free rate (say, the three-month rate) is higher than Japan's. An investor can borrow the money for three months in Japan, exchange the Japanese yen into the U.S. dollar and invest the money in a U.S. risk-free bond, which yields a higher interest rate than Japan's. After three months, the investor has to exchange the money denominated in the U.S. dollar back to the Japanese yen and repay the loan. Therefore, the total return of a carry trade strategy is the interest rate difference, which is positive, plus the change in the exchange rate during the three-month period, which could be positive (negative) if the dollar appreciates (depreciates).
The uncovered interest rate parity theory predicts an average expected return of zero for the carry trade investment strategy. For the zero return to occur, the positive gain from the interest rate difference must be offset by a decrease in the exchange rate, which implies a depreciation of the U.S. dollar. Otherwise, the carry trade can make a positive expected profit.
However, empirical studies have documented that the high-interest-rate currency does not tend to depreciate as predicted by the theory. Rather, they found that the behavior of exchange rates is actually well approximated by a property called a random walk: almost unpredictable in the short run, with the best forecast of future exchange rates being its current value.1 Finally, there is weak evidence that a high-interest-rate currency actually has a tendency to appreciate, which is consistent with the story described earlier.
In sum, the theory predicts that a rate hike in the U.S. should depreciate the U.S. dollar. In reality a higher interest rate may have very little or no effect on the exchange rate, given the strong empirical support of the random walk behavior of exchange rates in the short run.
1 Meese, Richard; and Rogoff, Kenneth. “Empirical Exchange Rate Models of the Seventies: Do They Fit Out of Sample?” Journal of International Economics, 1983, Vol. 14, No. 1-2, pp. 3-24.