For the past few months, most countries have been grappling with a major problem of inflation. Peak’s economics author George Graves continues his series of articles with a look at the latest developments.
Governments and central banks are facing a dilemma regarding how best to tackle the problem of inflation, and their responses have varied. An interesting consequence has been a very significant amount of volatility in exchange rates as foreign currency traders have assessed the feasibility and appropriateness of these policy responses.
The end of September 2022 saw a particularly high volume of trading in currencies with a record high for trading between the UK pound (sterling), the US dollar and the euro, which was 300% higher than normal.
On 21 September the US dollar “soared to a two-decade high” in response to the anticipated 0.75% increase in interest rates implemented by the Federal Reserve (the US central bank). This follows previous interest rate increases, and the expectation is that the policy will continue so that the interest rate will reach 4.4% by year end.
Rationale
For students of economics, it is very important to be able to link different components of the syllabus together and to understand the significant inter-relationships between inflation and exchange rates and the role of interest rates in influencing this relationship. Therefore, there is a strong link between macroeconomics and international trade through monetary policy (interest rates) and exchange rates.
However, to explain the recent volatility in the currency market we need to add some market dynamics such as trader confidence and policy credibility.
The case of the pound sterling
The increase in US interest rates makes holding US financial assets more attractive so the demand for dollars increases leading to an appreciation of the dollar. This accounts for the general rise of the dollar against all other currencies but the fall in the value of sterling against the US dollar was much larger than that of the other currencies – it registered a 50 year low of $1.03 (with an unprecedented fall of 7% between 23 and 26 September).
The reason for this dramatic fall was the market response to the UK government’s “mini budget”, which announced the intention to cut income taxes, cancel a scheduled increase in corporation tax, and to fund spending with additional borrowing. Lack of confidence in the government’s policy was virtually unanimous among traders and financial experts and the loss of credibility was so alarming that even the IMF took the unprecedented step of warning the UK government to reconsider this policy.
To prevent a further collapse of the currency and sell off of UK financial assets, the Bank of England felt obliged to intervene by making available a 65 billion pound facility to purchase government debt.
The case of the Turkish lira
The Turkish lira is another example of how lack of confidence in government policy can have a disproportionate effect on a country’s currency. The Turkish president is virtually alone in thinking that the best way to fight inflation is to lower interest rates and by insisting that the Turkish central bank does this the result is that the Turkish lira has depreciated against the US dollar by 75% over the past year. Consequently, raised import prices have pushed Turkish inflation to an OECD high of over 80%.
Insights
These examples highlight the interdependence between economic variables in the global economy and the significance of the leading role that the US dollar plays in determining the performance of the global economy. In addition, they show the importance of market sentiment in determining exchange rates and policy viability. The Turkish president has the power to force its central bank to cut interest rates, but is powerless to prevent the markets punishing the currency.