Inflationary Expectations – Fisher Equation

Inflationary Expectations – Fisher Equation

Fisher equation. Calculating Forex Inflation Expectations

In the first two articles of the series “Fundamental Laws of the FOREX Market”, we examined the relationship between the foreign exchange market and interest rates, the foreign exchange market and commodity prices. In the third and final part, we will examine the relationship between the foreign exchange market and inflation expectations, as well as link interest rates and inflation.

The interest rate parity law explains the pricing of futures exchange rates.  The Purchasing Power Parity Law explains how the cash exchange rate of a currency pair is formed. The Law on Inflation Expectations, named after Irving Fisher, a major economist of the XIX-XX centuries – the Fisher Equation, describes real and nominal interest rates, as well as the relationship between them.

The theory of the interaction of real and nominal interest rates is based on the fact that the borrower and the lender build their relations on the basis of real interest rates and the expected level of inflation. The logic of the Fisher equation is quite simple: the lender, wanting to make a profit, does not want to lose money due to inflationary depreciation, therefore he puts the expected inflation into his income.

  • Ryr (D) – real interest rate for term D;  
  • Ryn (D) – nominal interest rates for term D;  
  • Iye (D) – the expected change in price level for the term D, or inflationary expectations;

According to the equation, the real interest rate Ryr (D) in country Y, for a loan with a term of D days, is equal to the nominal interest rate Ryn (D), plus the expected change in the price level in country Y after time D. It is also assumed that investors form rational expectations regarding future inflation.

Applying the Fisher equation to ideal conditions of the global economy, it can be assumed that in the absence of trade barriers and restrictions on capital flows, real interest rates for all countries will gradually equalize as globalization develops, and changes in inflation expectations will lead to changes in exchange rates. Actually, we now see this when the central banks, following each other, begin to change their monetary policy.

However, we live in a world where trade barriers, as well as restrictions on capital flows, are applied in an increasing volume, which is reflected in exchange rates. 

Central banks and inflation expectations

The level of medium-term inflation is the main indicator that the central bank is guided by pursuing its monetary policy (Fig. 2). In the United States, Russia, or the European Union, a medium-term inflation target is a target, usually calculated over a two-year period. In the US and the EU, the medium-term inflation target is 2%. In Russia, the target inflation rate is 4%. In Canada and some other countries, a target rate of 2% is used as an indicator of inflation, but a range of 1 to 3 percent is considered. This allows the Bank of Canada to maneuver depending on the dynamics of inflation expectations.

As indicators that the central bank is guided by, various indicators of consumer inflation are usually taken, and these data can vary significantly in their characteristics. For example, the European Central Bank conducts its policy based on the Harmonized Index of Consumer Prices (HICP). The HIPC index includes 12 indicators of various goods and services: food, alcohol and tobacco, clothing, rental costs of housing and utilities, furniture, healthcare, transport, communications, culture, training, restaurant and hotel prices, other goods and services.

In its turn, the Federal Reserve System considers the so-called Core Inflation Rate indicator as an indicator, which does not include food and fuel expenses, since these costs, according to the regulator, are subject to significant short-term changes, which distorts the real picture. 

Typically, the central bank tightens monetary policy in the event of rising inflationary expectations and softens it in the event of lowering inflationary pressure, regulating liquidity in the banking system, thereby stimulating economic growth through cheaper money. It should be understood that the central bank makes a decision on its policy regarding the dynamics of inflation over a period of observation, usually for six months. Thus, current data may cause short-term fluctuations in the exchange rate, but at the same time, they will not force the bank to change its monetary policy, because the regulator considers the picture in a complex and can solve problems other than maintaining inflationary expectations.

One of the main methods of regulating monetary policy is to change the key interest rate. Usually, this is the lowest possible rate for borrowing, for the shortest time. For the USA, Japan, Canada, and the UK, the minimum possible loan term is one day, the so-called “through the night” operations. For the Eurozone, the minimum possible rate is for refinancing operations for a period of two weeks. By adjusting the key rate, the central bank sets the interest value for instruments with longer maturities and also changes the liquidity level in the banking system.

In general, the higher the key rate set by the central bank, the more expensive the currency issued by this central bank is, the lower the key rate, the cheaper the currency. Thus, the higher the inflation rates and inflation expectations, the more expensive the currency will be, and the lower the inflation, the cheaper the currency.

However, traders should remember that exchange rates are influenced by various, often multidirectional factors, and not just inflationary pressures. Also, do not forget that the currency quote consists of two parts. Thus, the difference between the interest rates of currencies included in the currency pair has the greatest impact on the exchange rate. At the same time, the differential in key interest rates, although it has a significant impact on the exchange rate, it is not the only indicator of the percentage ratio between the currencies of different countries. For example, traders should take into account the difference in the profitability of short-term and long-term instruments for different countries, but with the same level of reliability – treasury bills and bonds, as well as commercial rates Libor, Euribor, etc.

Separately, it should be noted the policy of central banks regarding the exchange rates that they issue. Maintaining the exchange rate, along with maintaining inflation, for example, is the task of the Bank of England and the Bank of Canada, but is not the direct responsibility of the European Central Bank and the Federal Reserve. In turn, the Reserve Banks of Australia and New Zealand always comment on their currencies, the Fed does it sometimes, and the ECB, on the contrary, never comments on the euro. Therefore, unlike inflation indicators, maintaining exchange rates is not always a priority for central banks. Rather, on the contrary, banks try to avoid direct influence on exchange rates and do this only in case of urgent need, coordinating their efforts with central banks of other countries.

Inflation Expectations and Treasury Bonds

Treasury bonds perform a very important function in the financial system of any state, providing not only budget financing but also determining the minimum level of profitability when investing in the currency of a given country, acting as a standard for determining the return on investment.

The modern world-system is the US dollar system. Therefore, US Treasury bonds play a very important role in world finance, and their level of return serves as a guide for numerous instruments denominated in dollars. In fact, the global financial system is a US debt system built to service US debt.

When deciding on an investment, an investor from the Eurozone compares the yield of European treasury bonds and bills with the yield of similar instruments in the United States, thereby increasing or decreasing the euro against the dollar under the Interest Rate Parity Act.

At the same time, there are treasury instruments in the United States that very accurately determine the inflationary expectations of investors. We are talking about the so-called Treasury bonds, protected from inflation – Treasury Inflation-Protected Securities (TIPS). This bond is inflation-indexed to protect investors from the negative effects of price increases. The core value of TIPS is that it grows with inflation. At the same time, comparing the yield of TIPS with fixed-income bonds, one can determine the inflationary expectations of investors.

For example, according to the US Treasury, on July 11, 2019, the yield on the 10-year US Treasury bond was 2.13%. At the same time, the yield on a 10-year inflation-protected bond was 0.875%, from which it can be concluded that investors assumed average inflation of 1.255%, clearly lower than the target imputed by the US Federal Reserve by law. The difference between the yield on 5-year assets was 1.380%, which is slightly higher than that of bonds with a maturity of 10 years.

Other factors can also influence the price and value of bonds, however, it is not profitability that interests us, but its dynamics over a certain period of time, for example, over a year. Possessing this information, an experienced trader from an analysis of the difference in bond yields can gain an understanding of what actions the central bank will take and how they will affect the exchange rate of the currency pair of interest (Fig. 3). As can be seen from chart 3, at present, inflationary expectations of investors have been declining for a long time, which may be one of the factors that reduce the rate of the US Federal Reserve at one of the next meetings. 

Conclusion

The three main laws of the FOREX market — the Interest Rate Parity Act, the Purchasing Power Parity Act, and the Fisher Equation — play an important role in analyzing the fundamental components of exchange rates. However, traders should remember that we get the basic information from the price chart, and no matter how convincing our assumptions are, a lack of information can play a trick on us. Does this mean that fundamental analysis does not carry a useful function for us? Not at all. Understanding how the market works can provide us an invaluable service, especially when the fundamental trends break. But, if you work on timeframes below four hours, you should be careful in making decisions based on the findings of fundamental analysis.

Be careful and careful, follow the rules of money management.

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