Question

The Federal Reserve recently announced that it will keep US interest rates low for a longer period of time than previously announced. Using interest arbitrage, explain the effect that this announcement is likely to have on spot and forward exchange rates.

Answer 1

Changes in the federal funds rate can impact the U.S. dollar. When the Federal Reserve increases the federal funds rate, it typically increases interest rates throughout the economy. The higher yields attract investment capital from investors abroad seeking higher returns on bonds and interest-rate products.

Global investors sell their investments denominated in their local currencies in exchange for U.S. dollar-denominated investments. The result is a stronger exchange rate in favor of the U.S. dollar.

KEY TAKEAWAYS

• When the Federal Reserve increases the federal funds rate, it typically increases interest rates throughout the economy, which tends to make the dollar stronger.
• The higher yields attract investment capital from investors abroad seeking higher returns on bonds and interest-rate products.
• Increases or decreases in the fed funds rate have correlated fairly well with moves in the U.S. dollar exchange rate versus other currencies.

Understanding the Fed Funds Rate

The federal funds rate is the rate banks charge each other for lending their excess reserves or cash. Some banks have excess cash, while other banks might have short-term liquidity needs. The fed funds rate is a target rate set by the Federal Reserve Bank and is usually the basis for the rate that commercial banks lend to each other.

For example, as U.S. exports are sold to Europe, buyers need to convert euros to dollars to make the purchases. If the dollar is strengthening, the higher exchange rate causes Europeans to pay more for U.S. goods, based solely on the exchange rate. As a result, U.S. export sales may decline if the dollar is too strong.

Also, a strong dollar makes foreign imports cheaper. If U.S. companies are buying goods from Europe in euros and the euro is weak, or the dollar is strong, those imports are cheaper. The result is cheaper products at U.S. stores, and those lower prices translate to low inflation.

Cheap imports help keep inflation low since U.S. companies that produce goods domestically have to keep their prices low to compete with cheap foreign imports. A stronger dollar aids in making foreign imports cheaper and acts as a natural hedge for reducing inflation risk in the economy.

As you can imagine, the Fed monitors inflation closely along with the level of strength of the dollar before making any decisions regarding the fed funds rate.