Currency Quandaries of Late
Based on recent developments, I started an article on the policies of the Japanese and Swiss central banks but it’s growing too long and I keep seeing articles about the confusion today so I thought I’d write a short piece explaining a bit of what’s happening.
Photo by Piret Ilver on Unsplash
To catch everyone up on global central bank headlines: the Americans decided not to change (lower) interest rates and US inflation seems to be picking up, the Europeans also didn’t change (lower) interest rates and EU inflation seems to be slowing, the Swiss lowered interest rates and Swiss inflation is falling, and the Japanese raised interest rates and Japanese inflation is rising.
The confusion/ discussion in the media is around the Japanese and Swiss. The Japanese raised interest rates, but the yen is weakening. The Swiss lowered interest rates and the franc is strengthening. What a dilemma, the laws of economics have collapsed, it’s a crazy, upside down world… not really.
What Moves Exchange Rates: Interest Rates
For just a minute, imagine a world where everything is constant. Each country has its own interest rate and currency.
Higher interest rates “call” investment monies to them. So, when one country raises its local interest rate, global investors want to invest in the local economy to get those higher returns. To do that, they need to buy the local currency so they have the right currency to make a local investment.
If you’re in Mexico and want to invest in the US, you need US dollars. If you want to invest in Japan, you need yen. You sell your currency and buy the currency you want to invest in. That drives up demand for the currency you are buying. When demand for something rises, it raises the value of that thing. Currency is no different. Therefore, this raises the value of the local currency1.
Based on this, when Japan raised interest rates, it should have “called investment” to Japan, raising demand for yen which should have raised the value of yen. And, when the Swiss lowered interest rates, it should have done the opposite: “shoo away” investment, decreased demand for francs and hence lowered the value of the franc.
The opposite seems to have happened.
What Else Moves Exchange Rates: Inflation
We need, however, to remember that we are talking about national currencies here. The other thing you care a lot about when considering how much of which currency to hold is what the inflation rate is in each country.
Inflation is the erosion of the value of a currency in terms of the goods you can buy with it. My $100 bought more groceries 5 years ago than it does today due to inflation. A lunch that used to cost $15 now costs $20 or $30. Each dollar buys less. That is the result of inflation.
Inflation therefore naturally drives people away from a currency. And, even more so, expected inflation, drives them away. When you hold some money, you don’t necessarily care what inflation was yesterday, but you care a lot about what it will be tomorrow. If you hold a mix of currencies, as many people around the world do, you want to hold less of the currencies that you expect to lose their value over the coming months and year(s).
Now we return to the same two countries. The Swiss lowered interest rates because inflation has been falling and is expected to continue falling. The Japanese raised rates because inflation has been rising and is expected to continue rising.
Push and Pull
Higher interest rates will increase demand for a currency (making it “stronger”) and higher expected inflation will decrease demand for a currency (making it “weaker”). That’s a push and pull on demand for the currency.
There should not be any confusion here. Markets are telling us that, weighing both these factors, people believe Swiss inflation will decline and/or stay low (it’s only 1.2% at the moment) and the drop in interest rates were more a result of the lower inflation or, better put, in line with the lower inflation. As a result, people are happy to hold more Swiss francs because it won’t be losing value and it’s, therefore, now more valuable relative to other currencies.
The situation for Japan is the opposite. The Japanese raised interest rates for the first time since 2016 because inflation finally looks like it will be positive and rising for a while. As a result, people want to hold less Japanese yen because it’s expected to lose value. A slightly higher interest rate wasn’t enough to counterbalance the weight of expected inflation.
I don’t see the big mystery here.
And, the Japanese have been struggling to get inflation up for 30 years (it’s big success today is only 2.8% inflation). They should be happy about this. Finally, markets are believing that they will see Japanese inflation.
Conclusion
It’ll be interesting to watch Japanese policy. There is already talk that, if the yen gets weak enough, the Japanese might intervene to strengthen it. My jaw almost dropped when I heard this because, if true, it tells us exactly why they haven’t been able to get inflation up for so long.
Exchange rates - which are just prices - being higher are a result of higher inflation and expected inflation, just like all other prices rising together in Japan are the result of inflation. The acts the central bank takes to “strengthen” the currency are the same actions needed to fight inflation; namely, higher interest rates and decreases in the money supply.
See my note from last summer on the Japanese economy: “The Japanese Warning2”. The central bank president was bragging that they were finally getting inflation into positive territory. If that’s their goal, they need to let it settle in and not undo their gains by fighting the currency’s depreciation. If they do fight it, then they are revealing to the world that they don’t really want higher inflation. Their pro-inflation stance will not be credible and that’s been their problem since the beginning.
It’s a funny world. Politicians and policymakers endlessly believe that they can have their cake and eat it too. Or, maybe I should say, enjoy the benefits and never pay the costs. We can spend and borrow but never have debt problems. We can keep interest rates low and never have inflation. We can have some inflation but our currency won’t lose value.
We can’t have our cake, eat it too but not put on the weight. Sorry.
For anyone with some interest in economic analysis, I have notes on an undergraduate-level supply and demand analysis for exchange rates that (I think) is pretty clear. Here’s a direct link (here) and my site for International Macroeconomics which I’m teaching this semester (here). You are welcome to any and all my material.
Sorry, as an economics professor I must comment that these are individual markets we are talking about and relative prices. Technically demand rising in one market (say for Japanese Yen) will raise the value of that thing relative to other things (say, other currencies). To be technically correct, I should write: “…this raises the value of the local currency in terms of other currencies (you can buy with it)”.