Hi all. we all know Interest rate has one of the biggest effects on the currencies. Here are several questions I'd like to get answers to, and I'm pretty sure I'm not the only one...
1) What is the reason for raising or lowering the Interest rate?
2) What is the effect on the currency?
3) Is the effect always the same? (for example, if unexpectedly interest rate changes upwards, will the currency always show bullish movement? or would it be different in other circumstances?
4) I've also read somewhere, that high interests might draw people from the stock market to the currency, nevertheless, the currency will drop because the stock market lost money and it's bad for a county's economy... --> is this true\possible?
This should probably be posted in the Fundamental forum. I am trying to learn some fundamentals myself to go with the technicals. I have always thought that a country would raise it's interest rate to prevent inflation, which in turn attracts more foreign dollars into the country, which in turn raises the value of the currency. I am not positive on this answer but below is a desciption that I obtained from http://www.forexfactory.com website describing interest rates. I love this site for news.
The central bank's governing body, the Federal Open Market Committee (FOMC), releases an Interest Rate Statement eight times per year. The statement contains the latest decision regarding changes to the nation's short term interest rate ("fed funds rate"), a brief report of the economic conditions that effected their decision, and most importantly, clues on what the next rate decision will be. A rising trend has a positive effect on the nation's currency. Short term interest rates are the paramount factor in currency valuation; traders look at most other indicators merely to predict how interest rates may change in the future. What makes interest rates so important is that high rates attract foreigners looking for the best "risk-free" return on their money, which significantly increases demand for the nation's currency. The primary objective of the central bank is to achieve price stability; when inflation rises above an annualized rate of approximately 2%, they will respond by raising interest rates in an attempt to bring prices down. This is what makes inflation-predicting indicators so important. Traders know that rising prices will lead the central bank to raise interest rates, which ultimately leads to a more valuable currency.
Originally Posted by parsush
hmm... no replies yet...
umm if it's laziness that prevents you guys from answering me, a link with detailed explaination would be appreaciated as well (however a direct answer for all questions would be the best... )
if it's ignorance, on the other hand - pipdiddy! crawler! pipslow! pippin! gump! help!!!
Thanks a lot topgun!
looking back, maybe I should have posted this on Fundamental forum. oh well. too late for that now.
it appears the answer you provided was accurate.
now we know that the interest-rate changes are made in order to maintain price stability. prices go up -> interest goes up.
but why would the feds (or ECB or whoever) mind if prices are going down (deflation)? seems like the money people have would worth more than before, since everything would be cheaper... why ruining it by lowering interest? not to mention scarying the foreigners away?
if you, Topgun, or anyone else, has an answer to this question, or the other questions remain unanswered:
will the currency necessarily gain more value by increasing interest?
is there any effect on the stock market that could actually hurt the value of the currency?
They are two different things. Disinflation is a decrease in the rate of inflation. Deflation occurs when prices deflate
While disinflation is generally perceived as positive, it is not good for the effect to go so far as deflation, which is generally perceived to be a very negative state for an economy.
During deflation, while consumers can buy more with the same amount of money, they also have less access to money. Consumers and producers who are in debt, such as mortgagees, suffer because as their income drops their payments remain constant
If you want to learn more about deflation, I recommend reading here.
Seems like deflation really is a negative thing.
Which is the optimal then? 0% inflation? is this what they should all aim for? (except for countries who try to weaken their currency in order to be competitive)
The role of a central bank is to provide price stability. If their economy is dying, they will not just sit on their hands and do nothing, since their currency value will depreciate. Instead, they will lower interest rates to kickstart a weak economy, which provides cheap access to money and forces consumers to spend rather than save (since savings rate is lowered). As more and more people get access to cheap money, due to increased consumer spending and businesss investments, the economy should improve (in theory), but at the consequence of money supply increasing, causing inflation to appear.
A rate cut is like flooring your gas pedal when driving but the car doesn't accelerate until ten minutes later. There is always lag between the actions of a central bank and its effect in the economy so if an economy is growing there will always be some kind of inflationary pressure.
Some central banks set explicit inflation targets. For example, the European Central Bank and the Bank of England, their present target for the level of inflation is to maintain inflation at a level below, but still as close as possible to the 2% mark. The US doesn't set an explicit target but their comfort zone is between 1 and 2%.
thanks a lot for the detailed answer. this clears things out.
so now I'll just sum up everything I've learnt for everyone to see:
all in all, interest rate is a tool the central banks use to control price stabilty, or in other words, inflation.
to decrease inflation, they raise interest and vice versa.
inflation in a steady market should range at about 1%-2% (in the western countries, anyway)
more or less than that, (hyper-inflation or deflation) would affect the market in a negative way.