The International Fisher Effect: An Introduction
The
decision to use a pure interest rate model rather than an inflation
model or some combination stems from Fisher's assumption that real
interest rates are not affected by changes in expected inflation rates,
because both will become equalized over time through market arbitrage;
inflation is embedded within the nominal interest rate and factored
into market projections for a currency price. It is assumed that spot
currency prices will naturally achieve parity with perfect ordering
markets. This is known as the Fisher Effect; not to be confused with the International Fisher Effect.
Fisher
believed the pure interest rate model was more of a leading indicator
that predicts future spot currency prices 12 months in the future. The
minor problem with this assumption is that we can't ever know with
certainty over time the spot price or the exact interest rate. This is
known as uncovered interest parity.
The question for modern studies is: Does the International Fisher
Effect work now that currencies are allowed to free float? From the
1930s to the 1970s, we didn't have an answer because nations controlled
their exchange rates for economic and trade purposes. This begs the
question: Has credence been given to a model that hasn't really been
fully tested? The vast majority of studies only concentrated on one
nation and compared that nation to the United States currency.
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The Fisher Effect model says nominal interest rates reflect the real rate of return and expected rate of inflation. So the difference between real and nominal interest rates is determined by expected inflation rates. The approximate nominal rate of return = real rate of return plus the expected rate of inflation. For example, if the real rate of return is 3.5% and expected inflation is 5.4%, then the approximate nominal rate of return is 0.035 + 0.054 = 0.089 or 8.9%. The precise formula is (1 + nominal rate) = (1 + real rate) x (1 + inflation rate), which would equal 9.1% in this example. The IFE takes this example one step further to assume appreciation or depreciation of currency prices is proportionally related to differences in nominal interest rates. Nominal interest rates would automatically reflect differences in inflation by a purchasing power parity or no-arbitrage system.
The IFE in Action
For
example, suppose the GBP/USD spot exchange rate is 1.5339 and the
current interest rate is 5% in the U.S. and 7% in Great Britain. The IFE
predicts that the country with the higher nominal interest rate (Great
Britain in this case) will see its currency depreciate. The expected
future spot rate is calculated by multiplying the spot rate by a ratio
of the foreign interest rate to domestic interest rate: 1.5339 x
(1.05/1.07) = 1.5052. The IFE expects the GBP to depreciate against USD
(it will only cost $1.5052 to purchase one GBP compared to $1.5339
before) so that investors in either currency will achieve the same
average return; i.e. an investor in USD will earn a lower interest rate
of 5% but will also gain from appreciation of the USD.
For
the shorter term, the IFE is generally unreliable due to the numerous
short-term factors that affect exchange rates and predictions of nominal
rates and inflation. Longer-term International Fisher Effects have
proven a bit better, but not by much. Exchange rates eventually offset
interest rate differentials, but prediction errors often occur. Remember
that we are trying to predict the spot rate in the future. IFE fails
particularly when purchasing power parity fails.
This is defined as when the cost of goods can't be exchanged in each
nation on a one-for-one basis after adjusting for exchange-rate changes
and inflation.
The Bottom Line
Countries
don't change interest rates by the same magnitude as in the past, so
the IFE isn't as reliable as it once was. Instead, the focus for central
bankers in the modern day is not an interest rate target, but rather an
inflation target where interest rates are determined by the expected
inflation rate. Central bankers focus on their nation's Consumer Price Index
(CPI) to measure prices and adjust interest rates according to prices
in an economy. The Fisher models may not be practical to implement in
your daily currency trades, but their usefulness lies in their ability
to illustrate the expected relationship between interest rates, inflation and exchange rates.
Source: Investopedia.com
