With the United States at the brink of a recession due to high inflation, the bond and equities markets in turmoil, and the US dollar strengthening against all other currencies, it is sometimes difficult to understand the relationship between inflation, interest and exchange rates. Listening to economists explain the whole interrelationship of these factors is also not easily comprehensible to the masses and may be true in theory in a perfect world but not in real life.
Using inflation as a starting point, increasing prices of goods and services is not a good thing, particularly when the rate of increase is higher. In its worst form, we have hyperinflation where the currency of the afflicted nation becomes almost worthless and the prices of goods and services keep on increasing by the minute. What are the typical causes of prices to go up? In simplified terms, this happens when demand becomes higher than the supply, or there are supply issues that prevent demand from being met.
Demand becomes higher when there is pent up demand, people have money or when the cost of debt is cheaper. All these things happened particularly in the United States. Due to COVID-19 lock downs and restrictions over the last two years restrained consumer demand. Naturally, when things opened up, there was a surge in demand. Due to the stimulus checks and other relief packages issued by the US Government to its citizens, consumers had the money to make purchases further increasing demand. Money was plentiful and the interest rate on consumer credit was low fueling more demand putting pressure to increase prices on goods and services.
Simultaneous to the increasing demand, there were supply issues that restricted the availability of certain raw materials and labor resources. It took a while for the supply chain to normalize due to the slowdown brought about by the global pandemic. The ongoing war in Ukraine and the sanctions against Russia caused artificial shortages in fuel supply that resulted in higher prices of petroleum and natural gas prices. Due to the increasing demand and the tightening supply, prices have nowhere to go but up.
In the hope of taming inflation, the response of the US Fed was to increase interest rates which they have been doing and will continue to do so for the near term. The rationale with a higher interest rate is to make the cost of consumer loans more expensive and hopefully curb demand appetite. However, in my view this approach is rather simplistic and does have some serious adverse side effects.
Raising interest rates not only increases the costs of credit for consumers but also the cost of funds for those making the goods and providing the services, which in turn are forced to raise prices to cover the higher cost of borrowing. This also shifts investments from equities into fixed income instruments since they now provide a better rate of return, causing a decline in the stock market. Since interest rates are also moving up, the prices of fixed income instruments such as bonds also decline to maintain parity with the higher interest rate.
Finally, how does interest rates affect exchange rates? In a fundamentally sound economy with a politically stable government, higher interest rates has the immediate effect of offering a better investment yield and more demand for that currency. As there is more demand for a currency, that currency, which in this case is the US dollar, becomes stronger which is exactly which is what is happening now.
Understanding how inflation, interest and exchange rates interact with each other is helpful. However, knowing what to do and how to do it is another story.(The views and comments of the author are his own and not of the newspaper or FINEX.
Dr. George S. Chua was 2016 FINEX President, an entrepreneur and also a professorial lecturer at the University of the Philippines, Diliman. Comments may be sent to [email protected])