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The Fed continued its campaign to raise interest rates, with a 75 basis point hike this week. One consequence of the monetary tightening has been big exchange rate moves, with currencies such as the pound hitting multi-year lows against the dollar.
In Focus - Joining The Rate Race
In times of old, central banks would raise policy interest rates when an economy appeared to be overheating and lower them when an economy needed a boost. That had largely fallen out of fashion in recent times, with rates constrained near zero. But the policy rate is now back.
The U.S. Federal Reserve this week set the target for the Fed Funds rate between 3% and 3.25% (the blue line in the chart). That’s the highest level since end-2007, in the windup to the global financial crisis. The 0.75 percentage point increase was the third large one in a row.
The rate hike was expected. Perhaps more newsworthy was the new set of economic projections the Fed released along with it. Each member of the policy-setting group indicates their forecast for key variables, including the Fed Funds rate. In June, the median projection was that the rate would climb to 3.4% in 2022 and 3.8% in 2023. Just three months later, the revised projections were 4.4% in 2022 and 4.6% in 2023. This has been a rapid tightening, but there’s more to come.
So how are these higher policy rates supposed to cool an overheating economy? Indirectly. While the Fed Funds rate directly affects certain very short-term borrowing, the changes tend to pass through to longer commercial interest rates that affect economic activity. As just one example, average mortgage rates this week hit 6.29%, the highest in 14 years. One year ago, the equivalent mortgage rates were 2.88%. Those higher rates make home-buying more expensive; when home buying slows, so do all the purchases and services that tend to come with it.
Big policy rate moves can also have dramatic effects on exchange rates and trade, particularly if other central banks are not moving at the same pace (see the chart). To oversimplify, an international investor sees higher interest rates as good and higher expected inflation as bad. If investors compare the British pound and the US dollar and see lower interest rates and higher expected inflation in the UK, as they did in the wake of a newly-announced tax cut, they are likely to move their money out of pounds and into dollars, driving the pound down relative to the dollar.
At the start of this year, one euro cost $1.14. As of Friday, that had fallen to 97¢, a euro depreciation of roughly 15%. The British pound fell from $1.35 at the start of the year to below $1.09 on Friday, a 19% drop. The percentage fall in the Japanese yen has been comparable. This dollar appreciation makes US exports look more expensive, thus further relieving pressures on US production. It makes goods from the US – or those priced in dollars, like oil – look more expensive abroad.
The pound this week fell to its lowest level since 1985, which happens to be the year of the last major concerted currency market intervention. Such unsettling swings can be part of old school central banking, too.
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