Fed to keep interest rates near zero for 2 years

FX Strategy Articles > Fundamental articles

The Federal Reserve in the U.S today announced that interest rates in the U.S would be likely to remain near zero for the next two years. Low interest rates in the U.S are nothing new in recent times, however, the Federal Reserve coming out an explicitly stating that rates will remain near zero to mid 2013 is the first time that the Fed has pegged a rate for a defined period.

The extraordinary statement is a measure of the depth of the problems in the U.S, that the Federal Reserve believes economic prospects are so low that growth and inflation is unthinkable. The statement is clearly designed at installing some confidence in financial markets and for borrowers. Borrowers can be certain that the interest rates they will be paying for the foreseeable future will be low. This may encourage borrowings and investment in the business sector in the short to medium term which is aimed at stimulating economic growth in the longer term.

You might think that the net effect on foreign exchange markets will be that the U.S dollar will deprecate against other currencies. You might think that with interest rates so low, with no prospect of an increase, there will be a net outflow of the U.S currency towards bonds in other countries  that yield a higher return. For example, if you buy Australian Bonds in AUD you can get a 6% + return risk free. The issue with your analysis is that that FX rates are determined by interest rate differentials and not the actual physical rates. We now have a peculiar situation where the U.S can not go up and can go no further down (assuming the Fed doesn’t allow negative interest rates which happened in Japan a few decades ago). Assuming that FX rates are largely set by interest rate differentials then the U.S has no control on their currency, they are at the mercy of economic prosperity of other countries.

Published on 10th of August 2011
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