Introduction to the International Fisher Effect

What is the international Fisher effect?

The International Fisher Effect (IFE) is an exchange rate model designed by economist Irving Fisher in the 1930s. It is based on current and future risk-free nominal interest rates rather than pure inflation, and is used to predict and understand current and future spot currency price trends. In order for this model to work in its purest form, it is assumed that the risk-free aspect of capital must be allowed to flow freely between the countries that make up a particular currency pair.

Fisher effect background

The decision to use a pure interest rate model instead of an inflation model or a certain combination stems from Fisher’s assumption that the actual interest rate is not affected by changes in the expected inflation rate, because over time, both will be arbitrage through the market. Balance; Inflation is included in the nominal interest rate and is included in the market forecast of currency prices. Assume that the spot currency price will naturally be at par with the perfect order market. This is called the Fisher effect and should not be confused with the international Fisher effect. Monetary policy affects the Fisher effect because it determines the nominal interest rate.

Fisher believes that the net interest rate model is more like a leading indicator that can predict the spot currency price in the next 12 months. A small problem with this assumption is that over time, we can never know the spot price or the exact interest rate with certainty. This is called unpaid interest parity. The question of modern research is: Since the currency is allowed to float freely, is the international Fisher effect effective? From the 1930s to the 1970s, we did not have an answer, because countries controlled their exchange rates for economic and trade purposes. This begs the question: Has trust been given to models that have not yet been fully tested? The vast majority of research focuses on only one country and compares that country with the U.S. currency.

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Fisher Effect and IFE

The Fisher Effect model says that the nominal interest rate reflects the actual rate of return and the expected inflation rate. Therefore, the difference between the real interest rate and the nominal interest rate depends on the expected inflation rate. The approximate nominal rate of return is equal to the actual rate of return plus the expected inflation rate. For example, if the actual rate of return is 3.5% and the expected inflation rate is 5.4%, then the approximate nominal rate of return is 0.035 + 0.054 = 0.089, or 8.9%. The exact formula is:

RR nominal = (1 + RR real) ∗ (1 + inflation rate) where: RR nominal = nominal rate of return RR real = actual rate of return begin{aligned} &RR_{text{nominal}} = left(1 + RR_{text{real}}right)*left(1+text{inflation rate} right )\ &textbf{where:}\ &RR_{text{nominal}}=text{ Nominal rate of return}\ &RR_{text{real}}=text{Actual rate of return}\ end{aligned}

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resistanceresistanceNominal=(1+resistanceresistancereal)(1+Inflation rate)Where:resistanceresistanceNominal=Nominal rate of returnresistanceresistancereal=Actual rate of return

In this example, it is equal to 9.1%. IFE further assumes that the appreciation or depreciation of currency prices is proportional to the difference in nominal interest rates. Nominal interest rates will automatically reflect differences in inflation through purchasing power parity or no-arbitrage systems.

IFE in action

For example, suppose that the GBP/USD spot exchange rate is 1.5339, the current interest rate in the United States is 5%, and the United Kingdom is 7%. IFE predicts that countries with higher nominal interest rates (in this case, the United Kingdom) will see their currencies depreciate. The expected future spot interest rate is calculated by multiplying the spot interest rate by the ratio of the foreign interest rate to the domestic interest rate: 1.5339 x (1.05/1.07) = 1.5052. IFE expects that the pound will depreciate against the U.S. dollar (it only costs 1.5052 U.S. dollars to buy 1 pound, compared with 1.5339 U.S. dollars), so investors in both currencies will get the same average return (that is, U.S. dollar investors will get a lower interest rate of 5% but also Will benefit from the appreciation of the U.S. dollar).

From a short-term perspective, IFE is generally unreliable due to many short-term factors that affect exchange rates and projections of nominal interest rates and inflation. The long-term international Fisher effect has proven to be better, but not much. The exchange rate will eventually offset the difference in interest rates, but there are often forecast errors. Please keep in mind that we are trying to predict future spot exchange rates. IFE fails, especially when purchasing power parity fails. This is defined as a situation where the cost of goods cannot be exchanged one-to-one in each country after adjusting for exchange rate changes and inflation. (For related reading, please see: 4 ways to predict currency changes.)

Bottom line

Countries will not change interest rates by the same amount as in the past, so IFE is not as reliable as before. On the contrary, the focus of modern central bankers is not the interest rate target, but the inflation target, in which the interest rate is determined by the expected inflation rate. Central bankers pay attention to their country’s consumer price index (CPI) to measure prices and adjust interest rates based on prices in the economy. Implementing Fisher models in your daily currency transactions may be impractical, but their usefulness lies in their ability to illustrate the expected relationship between interest rates, inflation, and exchange rates. (For more information, see: Use interest rate parity to trade foreign exchange.)

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