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.
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.