Below Bill Poulos explains the relationship between interest rates and the value of currency:
There is a fundamental relationship between a countries’ interest rates and a countries’ currency value. Let’s discuss this and how a central bank like the Federal reserve or the Bank of England for examples, can change the interest rates in those countries. First, the Central Bank sets monetary policy to help regulate their nation’s currency. Monetary policy is responsible for helping to maintain a “stable” currency so the nations commerce can take place. The central bank has several “levers” to use. One major lever that the central bank (the Federal Reserve in the U.S) uses is to control the interest rates in the county by raising or lowering the FED fund rate or the rate at which banks lend to each other (kind of the Wholesale interest rate) Bank then use this FED Funds rate to set all other rate of interest for saving and borrowing. Therefore, by raising or lowering the FED Funds rate in the economy the Fed has a powerful tool to leverage the activity of the economy. When the central bank lowers rates for example in late 2008 through 2015 keeping the Rate historically low levels. The Central bank runs the risk of weakening the Nation’s currency. Why you ask?
Generally speaking, when a central bank lower interest rates, the rate of return is lower for Bond and other fixed income securities. With lower yields, investors are then free to go else where to find higher rates of returns on their investment. Often this will result in money or capital flowing out of the country that reduced rates and into countries with higher rates. This happen because as people sell the one currency for another currency they literally exchange the currencies, so the can invest or buy securities in the country with the higher returns. This out flow of money will generally reduce the demand for that country where the capital is leaving and increase the demand for the currency in the country where the capital is moving. This Increase/decrease of demand will drive the prices or value of the currency higher or lower.
For example, as the Fed raises rates which is currently is in the mood to do, the dollar should over time strengthen. Of course, this is assuming that all else being equal. In the several years after the great recession if 2008, the FED lowered the FED funds rate to all time historical lows, but the U.S dollar didn’t collapse or fall apart. First of all; why did the US Federal reserve cut rates so dramatically? This was done in the aftermath of the financial crisis to encourage spending, new capital spending, and lending in the economy, while this did happen; why didn’t the U. S dollar collapse with rates so low. The answer to that question is: where was a better place for that money to go? As the financial crisis moved throughout the western economies, other central bank, including Bank of Canada, the Bank of England, and the European Central Bank (ECB) all cut interest rates for the same reason as the US Federal reserve. So in short, the US dollar has remained generally strong, because all of the other major currencies have also had low interest rates. So, on a relative basis, the U.S. dollar has continued to be the major reserve currency at least for the present time.
As the Fed raises rates, this will strengthen the U.S dollar, but they move very slowly, so as not to disrupt fragile economic growth. Also, as a currency strengthens with higher interest rates and becomes more valuable this can have a negative effect on the price of exports, making selling goods abroad might be impacted. The central banks and FED in particular, have a balancing act to perform, and a lot of responsibility when it comes to monetary policy, which can affect the economy both for better or worse.