Question

According to a newspaper column in 2007, “The Bank of England published minutes showing that only the narrowest possible margin, 5-4, voted down an interest rate increase last month. Nobody foresaw this. The news took sterling [British pound] back above $1.99, and to a 15 year high against the yen.” What could explain the appreciation of the pound when interest rates did not change? Use a diagram of the FX market in your answer.

Answer 1

It is important to note that the currency market not only discounts the current news, but also the future expectations. It is clear from the above discussion that an increasing number of members in the Bank of England decision making on rates are tending towards interest rate hike.

The implication is that whenever the Bank of England meets for the subsequent policy decision, it is very likely that the voting is in favor of a rate hike. When interest rates are hiked in the UK and the interest rates remain the same in Japan, there is likely to be a flow of funds towards the UK because it becomes a relatively attractive investment destination.

The currency market is already making that move (discounting the future) with flow of funds into the United Kingdom. This implies that Yen is being sold and the British Pound is being purchased. This creates incremental demand for the Pound and it has witnessed appreciation. Tighter monetary policy also implies relative tightening of liquidity, which translates into currency appreciation. Therefore, these factors are discounted in the appreciation of the British Pound.

The FX chart below gives the initial demand and supply curves as D and S respectively. When the announcement by policymakers is made, the demand for the Pound increases and the demand curve shifts to the right to D1. The quantity of Pound demanded increases from an initial "Q" to "Q1."

At the same time, one pound bought "E" number of Yen. After the announcement, one Pound can buy "E1" number of Yen, which indicates an appreciation in the Pound against the Yen.