4. Structure of Currency Markets

Finally, the structure of the currency markets may work against elimination of the forward rate bias. Note that the forward rates depend only on the spot rate and the difference in interest rates. For arbitrage reasons, the forward rate cannot depend on anything else (see the discussion of interest rate parity in “Description,” above). However, an exchange rate between two currencies reflects the relative state of the two economies. If the U.S. economy is expected to do better than the Japanese economy, then the spot exchange rate will reflect that. Any changes in growth expectations will promptly cause a change in the spot exchange rate and thereby in the forward exchange rate. For example, the dollar strengthened from 1995 to 2000 because of the relative strength of the U.S. economy. During 2002 and early part of 2003, when expectations about U.S. economic growth were constantly revised downward, the dollar kept losing ground to other currencies.

FundsTo understand how the structure of currency markets can affect the forward rate bias, it is necessary to comprehend the connection between interest rates, inflation, economic growth, and currency values. Central banks and financial markets are concerned about inflation because inflation adds to uncertainty or risk. If inflation is expected to rise, the Federal Reserve, in an attempt to control inflation, will raise short-term interest rates. Typically, inflation is expected to rise when the economy is growing too fast, and is expected to fall when the economy is not growing fast enough. The Japanese economy has been sputtering for the last decade and its interest rate is 0.1 percent per year, as there is no fear of inflation.

If this line of reasoning is stretched a bit, it means that interest rates and growth expectations are related. In general, countries that have interest rates less than their long-term steady-state interest rate are expected to grow less than countries that have interest rates more than their normal level. Look at the effect on the forward rate. If a country has a low interest rate, it is expected to underperform in terms of economic growth. Therefore, the currency should fall in value in the future. However, the forward rate suggests that lowinterest-rate currencies must appreciate, not depreciate. Perhaps the negative b can be explained in this way. Currencies with lower interest rates tend to fall because of reduced growth expectations, in spite of what the forward rate predicts.

If markets are efficient and if market participants realize that growth expectations may be cut, then the currency value should depreciate immediately in the spot market, not sometime in the future, as implied above. Once the currency depreciates immediately in the spot market, the forward rate can still be unbiased. That brings up another issue relevant to currency markets: role of the government in trying td influence exchange rates. The exchange rate (dollar value or yen value) is one price that governments would like to control if they could. Why do they want to control a currency’s value? Because the currency value affects the economy in many ways. A strong currency keeps inflation in check and makes foreign goods less expensive. At the same time, a strong currency hurts exporters. If the exchange rate is very volatile, it increases the risk of trading, meaning that firms will be less willing to trade with other countries. So a government would like to keep its currency value stable— not let it strengthen too much or weaken too much. For example, the Japanese government tries to keep the yen from strengthening against the dollar to protect its balance of trade. Though the currency markets are huge monsters, they cannot ignore a government’s stance because the government can influence the spot exchange rate temporarily through direct intervention in the currency markets and permanently by changing interest rates.

A government may also use the exchange rate as a tool for jump- starting the economy. If the economy is doing poorly and inflation is not a threat, the government may want the currency to fall in value, so that exports increase along with domestic production. Japan fits this scenario perfectly—the Japanese government would like to see the yen fall in value. This is the same scenario as before: low economic growth, low inflation, and low interest rates should be followed by a falling currency resulting in the forward rate bias. Thus,it seems that the role of government in currency markets may be an important factor in the forward rate bias. If the structure of currency markets contributes to the forward rate bias, it will persist until governments stop trying to influence exchange rates—something that is unlikely to happen.

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