Never reason from an interest rate spread
By Scott Sumner
Here’s the Financial Times:
Analysts have struggled to explain why the yen is rising when the gap between US and Japanese interest rates is widening further, with the US Federal Reserve tightening policy while the BoJ is pinning 10-year bond yields at zero.
Possible answers include a belief that the BoJ will soon tighten policy, reduced confidence in the dollar because of the rising US budget deficit, or technical factors relating to the end of the Japanese fiscal year in March.
That final suggestion is interesting, as massive US budget deficits are the standard explanation of the strong dollar of 1983-85.
When thinking about the relationship between any two macro variables, I always start with the extreme cases, much like physicists like to do experiments under extremes of heat and pressure.Â It exposes a lot of relationships that are more difficult to see under ordinary conditions.Â Let’s start with recent trends in Argentine interest rates:
So Argentine interest rates are far higher than US rates, and trending upward.Â How would you expect that to impact the value of the Argentine peso? Over that same period, the peso has fallen from 20 cents to 5 cents:
Now you might argue that I’ve cherry picked the Argentine example.Â But actually this example is typical of countries with very high interest rates.Â Doesn’t it seem plausible that if very high interest rates cause a currency to depreciate sharply, then modestly higher interest rates might cause a currency to depreciate modestly?
Of course this is one of those “never reason from a price change” cases.Â Yes, there really are cases where rising rates in the US are associated with a stronger dollar—the FT is not stupid.Â The actual correlation entirely depends on what causes rates to change in the US, and in Japan.
Notice that the FT article cites a “tightening” of monetary policy in the US.Â But they provide no data to support their claim that monetary policy has become tighter.Â I’ll provide data for the opposite claim.Â NGDP prediction markets show 4.7% growth up through Q1, and 4.4% expected growth over the next 12 months.Â Those figures are a bit higher than recent trends, which suggests to me that the Fed has been easing monetary policy.
Is there any data suggesting that the Fed is tightening monetary policy?Â (And please, don’t even go there . . . )
Their comments about expected Japanese tightening are plausible.Â It would be crazy for the BOJ to tighten right now, but weirder things have happened in central banking.Â It would probably help to look at the yen vs. the euro, and other exchange rates, to get a sense of whether this recent move in the exchange rate is more about the dollar or more about the yen.