International Fisher Effect
The International Fisher Effect is an exchange rate model designed by Economist Irving Fisher in the 1930’s that is based on present and future risk free nominal interest rates rather than pure inflation to predict and understand present and future spot currency price movements. In order for this model to work in its purest form, it must be assumed the risk free aspects of capital must be allowed to free flow between nations that comprise a particular currency pair.
The derivation of the separation to use a pure interest rate model rather than an inflation model or some combination stems from the assumption by Fisher in the 1930’s that real interest rates are not affected by changes in expected inflation rates because both will become equalized over time through market arbitrage.
Inflation is embedded within the interest rate and factored into market projections for a currency price. So it is assumed that spot currency prices will naturally achieve parity with perfect ordering markets.This is known as the Fisher Effect and not to be confused with the International Fisher effect. So Fisher believed the pure interest rate model was more of a leading indicator to predict future spot currency prices 12 months in the future.
The minor problem with this assumption is that we can’t ever know with certainty over time the spot price or the exact interest rate. This is known as Uncovered Interest Parity. The question for modern studies is does the International Fisher Effect work now that currencies are allowed to free float.From the 1930’s to the 1970’s, we didn’t have an answer because nations controlled their currency price for economic and trade purposes. So only in the modern day has credence been given to a model that hasn’t really been fully tested. Yet the vast majority of studies only concentrated on one nation and compared that nation to the United States currency.
International Fisher Effect calculations 12 months in the future work like this. Multiply the current spot exchange rate by the nominal annual US interest rate then divide by the annual rate of another nation. For example suppose the GBP/USD spot exchange rate was 1.5339 and the current interest rate in the US is 5 percent and 7 percent in Great Britain.
What is expected 12 months in the future. Calculate ( 1.5339 X 1.05) X 1.07 = 1.7233.
Investors would sell the USD against the GBP to allow the free flow of capital to float between these nations and profit. What if we looked at this interest rate model in terms of inflation and the Fisher Effect to account for the 2 percent difference in yield.
The Fisher Effect model says nominal interest rates reflect the real rate of return and expected rate of inflation. So the difference between real and nominal rates of interest is determined by expected rates of inflation.
The nominal rate of return = real rate of return X expected rate of inflation.
For example, if the rate of return is 3.5% and expected inflation is 5.4 % then the nominal rate of return is 0.035 + 0.054 + ( 0.035 X 0.054) = 0.091 or 9.1 percent. The International Fisher Effect takes this example one step further to assume appreciation or depreciation of currency prices is proportionally related to differences in nominal rates of interest.
Nominal interest rates would automatically reflect differences in inflation by a purchasing power parity or arbitrage system. Suppose inflation in the UK is 10 percent and 3 percent in the US and the spot rate is GBP/USD 1.4. Expected GBP/USD is 1.5 = (1+ 0.1) X ( 1+ 0.03) = expected GBP/USD = 1.5.
A number of factors could occur with these models however. What would happen if nominal interest rates are the same within a currency pair. The twofold answer is either stay invested in the home nation because expected returns are not known or focus on inflation in either of the two nations for possible investment opportunities.
Yet this goes against the grain of the model and is not a good predictor of currency movements. The Fisher Effect has proven that dramatic effects can occur within currency pairs by changes in interest rates and inflation if investors are on the right side of the market. The above GBP/USD example has proven correctly but what if the trade was USD/GBP.
This trade would’ve had dramatic losses. For the shorter term, the Fisher Effect has proven to be a disaster because of the short term predictions of nominal rates and inflation. Even with perfect market information, investors buying shorter term T-Bills would’ve fared much better than investing in currency pairs.
Longer term International Fisher Effects have proven much better but not very much. Interest rates eventually offset exchange rates but prediction errors have been known to occur. Remember we are trying to predict 12 months in the future. IFE fails particularly when the cost of borrowing or expected returns differ or when purchasing power parity fails. This is defined when the cost of goods can’t be exchanged in each nation on a one for one basis after adjusting for exchange rate changes and inflation.
The interesting failure of these models is the focus on nominal interest rates and inflation. The modern day doesn’t see the big interest rate changes as once happened just 20 years ago. One point or even half point nominal interest rate changes rarely occurs anymore.
Instead the focus for central bankers in the modern day is not an interest rate target but rather an inflation target where interest rates are determined by the expected rate of inflation. Central bankers focus on their nations Consumer Price Index to measure prices and adjust interest rates according to prices in an economy. To do otherwise may cause an economy to fall into deflation or stop a growing economy from further growth. So a 12 month interest rate target and 12 month exchange rate target can only be measured in 1/4 points at best in the modern day. Does this leave these models in the backseat for the modern day. The answer is probably yes until a new model is developed with the thought that all models includes these served an effective purpose.
December 2009 Brian Twomey
Brian Twomey is a currency trader and adjunct professor of Political Science at Gardner-Webb University