Can interest rate cuts raise foreign exchange rates?

Can interest rate cuts raise foreign exchange rates?

It is possible to use interest rates as a policy tool for many aims, such as to control monetary expansion for the sake of financial stability and to stop a surge in inflation or, on the contrary, to stimulate total demand during a serious recession and to avoid an overvaluation of the domestic currency, which is harmful for foreign trade and current account balances.

It is generally accepted that that a considerable cut in interest rates decreases the attraction of investing in the Turkish Lira, causing demand to shift to foreign currencies. As a result, foreign exchange rates will increase, overvaluation of the lira will diminish and, consequently, exports will increase considerably as imports naturally decrease after gaining a fresh advantage in foreign and domestic markets, bringing necessary relief to national companies and current account problems. It is expected that the recent interest rate cuts will start that process.

In many cases in Turkey, however, when foreign exchange rates increased even without any intervention into interest rates, there has been only a slight development in trade balance, which was not the expected result. And sometimes drops in interest rates did reduce the attraction of investing in the lira but did not stimulate demand for foreign currencies. This taught us that the relationship among interest rates, foreign exchange rates, imports and exports is not as simple as imagined.

For a long time, businesspeople, economists and opinion writers insisted that all governments during the last decade intentionally implemented a “high interest-low exchange rate” policy which resulted in a deterioration in foreign trade and current account balances. Obviously there was not such an intention, but that situation was a practical result after the shift from a policy of favoring a fixed exchange rate to one favoring a flexible one to stop the rapid foreign exchange outflow during the 2001 crisis. After deciding to implement a flexible foreign exchange regime, it is almost impossible to change one’s mind, as that could create more serious current account problems.

The Central Bank is said to be looking at cutting interest rates in order to prevent an overvaluation of the national currency. This started a new discussion. What level of interest rates is feasible and reasonable for this aim? The decision will and must be taken by the Central Bank with the support of other authorities who are responsible for economic affairs. This is not as easy as thought. There might be risks for any level because of the difficulties of estimating the reaction of the markets beforehand.

Lower interest rates might shift investments from the lira to foreign currencies and might increase foreign exchange rates. This will have a positive effect on foreign trade and current account balances but, on the other hand, it might push up inflation. The inflationary effect of low interest rates must also not be neglected. In short, it is not easy to calculate the net effect of this operation on the economy. It must be remembered also that low interest rates might negatively affect already-weak domestic savings, which is one of the main reasons for the current account deficit. In addition, the inflationary effect of higher foreign exchange rates must again not be forgotten.

My aim is not, of course, to draw a very complex economic scenario but to explain how difficult it is to take a decision on key elements of the economy. For that reason, economists and the heads of important institutions invented a new term which is not very scientific but vey practical: “fine-tuning.”

Unfortunately, neither national economies nor the world economy now resemble any musical instrument. Any attempt to fine-tune might just create music to the ears of the tone deaf.