Predicting exchange rates is not as easy as some experts may suggest. There are many factors at work in determining exchange rates – economic fundamentals are only part of the equation. To predict future exchange rate movements we need to look at a variety of factors. The most important include:
Interest Rate Movements.
Interest rates have the biggest single effect in determining exchange rates. Higher interest rates make it more desirable to save money in that particular country. This causes an inflow of hot money which leads to an appreciation in the exchange rate. International hot money flows account for a high % of capital flows.
Economic Prospects
Linked to interest rates is the general economic prospects of an economy. If an economy is slowing down, due to say falling house prices, it is likely that interest rates will fall. This is because when the economy slows down, inflation falls allowing Central Banks to cut interest rates. E.g. slower growth in the US has caused expectations of interest rates to fall, this in turn has led to the devaluation of the dollar.
Expectations / Confidence
This is an important factor which is harder for Economists to quantify. When Keynes was formulating his general theory, he used the rather unscientific term ‘animal spirits’. Here he was referring to business confidence. But it would not be entirely inappropriate to explain sentiments in foreign exchange markets. If people expect a currency to devalue, then it can become a self fulfilling prophecy. Because people expect the currency to fall, they sell and this causes the currency to fall. Because of the importance of expectations and market sentiment, currencies can often become divorced from economic fundamentals. This means that currencies can overshoot or undershoot their expected value.
- For example, 2007 saw a weak dollar due to falling interest rates, however, the bearish sentiment caused the dollar to fall by more than perhaps was warranted. the Pound reached $2.12 before falling back to $1.95 a few weeks later. Like other markets, currencies can get caught up in their own hype – making forecasting a difficult business.
Long Term Competitiveness
It is argued that in the long term exchange rates will change to equalise differences in purchasing power. An example of this is using the Economist’s Big Mac index. This shows the local dollar price of buying a big Mac. Countries where a Big Mac is very expensive, in theory, have an overvalued exchange rate. In principle, their exchange rates should fall in the long term to equalise the purchasing power of the currencies. However, currencies can be ‘overvalued’ or ‘undervalued’ for a long time due to other factors like general economic confidence.
Example, the dollar is weak, making it cheaper for Europeans and Canadians to buy American goods. In theory, this should lead to a long term appreciation in the dollar. However, in practise, their is no guarantee that this will occur.
Good points. I live in Asia, and what I see is that these countries are so export dependent and have so much excess capacity that if the US demand for their goods declines, as it will, their currencies will decline as well, due to internal stresses, regardless of interest rates. And it would be silly to increase interest rates just when demand was falling for goods. There were some predictions that the Peso would end up at 37 per dollar, but if I were buying dollars I would have started already, at 40.80. So much of the economics of the world is dependent on the US economy that it’s not like the dollar is independent of the rest, free to rise and fall on its own. Oil prices showed an immediate reaction to the dollar decline, which acted as a buffer on the dollar decline. Even the Euro has its own weakness, as its production and manufacturing is being undercut by the Asian countries. I like the Big Mac index myself, and they are quite cheap here in the Philippines. Also, I am not retired, I am an attorney that does his work in the US while living in Asia. I did get entirely out of the stock market recently although I missed the peak by a few days. Bank loan rates here are at 12% but inflation is about 7%. And the growth rate is about 7% as well. Thanks for a well written blog.