Interest rates ; Capital movements ; Foreign exchange rates

Adrian W. Throop

English

Research Papers in Economics

FABSF WEEKLY LETTER
Number 94-29, September 2, 1994
Linkages of National Interest Rates
Figure 1
Real Short-Term Interest Rates
Percent
eign exchange relative to spot foreign exchange
equals the difference between U.S. and foreign
interest rates. In the 1980s the average absolute
difference between u.s. and covered foreign
short-term interest rates has been only about
25 basis points.
Linkages under fixed and flexible exchange rates
Under a system offixed exchange rates, such as
the Bretton Woods system that existed from 1946
to 1973, nominal interest rates at home and
abroad tend to be closely linked in the absence
of governmental controls over capital flows. The
.'.
~... ..-. -. ., .
Foreign
83
u.s.
81
4
2
8
6
-4
O-l-'t-'-----..::I.........------- .....7-
'\ ....r\
\., /. \
U.S. - F~reign \/\ 1\ i
\.... \.\/
-6 -+--,--,-.,.....,.....,....,...---r----r---r--r---r~__.
85 87 89 91 93
·2
These results indicate almost a complete absence
of institutional or governmental barriers to inter~
national flows of capital. But they do not neces-
sarily imply an equality between U.S. and foreign
real interest rates, that is, nominal interest rates
adjusted for inflation. The reason is that the pre-
mium or discount on the forward cover does not
necessarily equal the difference in inflation rates.
As a result, as seen in Figure 1, differences be-
tween U.S. and the trade-weighted measure of
foreign real interest rates can persist despite the
existence of a parity in covered returns.
As government-imposed barriers to the interna-
tional flow ofcapital between the major industri-
alized countries were relaxed in the 1970s and
virtually eliminated in the 1980s, the interna-
tional·integration of financial markets increased
dramatically. Some have arguedthat the inter-
national integration offinancial markets would
tend to equalize real interest rates at home and
abroad, making them move closely together over
time. But the data do not support this argument.
The U.S. real interest rate on 91-day Treasury bills
first rose well above that on a trade~weighted
measure of rates on comparable foreign money
market instruments in the early 1980s and then
fell well below such rates afterward (Figure 1).
The reason for the divergence hasto do with the
operation of a system offlexible exchange rates.
This Weekly Letter first discusses the evidence for
the existence of a high degree of international
integration of financial markets since the early
1980s. It then explains the effect that such inte-
gration would be expected to have on real inter-
est rate differentials under a system offlexible
exchange rates, as opposed to one of fixed rates.
Finally, it presents estimates ofthe response of
the differential between u.s. and foreign real
interest rates to shocks to either rate.
Evidence of financial market integration
Nearly complete international integration of
financial markets, at least for relatively large bor-
rowers and lenders, is indicated at the short end
of the market. u.s. rates tend to move closely
together with major "covered" foreign interest
rates, that is, covered against exchange rate
uncertainty in the forward market. The forward
market allows a u.s. investor to sell foreign
exchange in the future at a price that is known
today, thus eliminating uncertainty in the dollar
denominated return on foreign assets: Dealers in
forward exchange require a price that compen-
sates them for the expected change in the ex-
change rate and the risk that the actual change
may turn out to be different from expectations.
Given the availability of such forward cover, in-
vestors in fully integrated markets tend to bid the
spot and forward prices of foreign exchange to
the point at which the premium on forward for-FRBSF
reason is the near absence of exchange rate
uncertainty when exchange rates are fixed by
monetary authorities to within a small deviation
from the official parity. Capital tends toflow to
that economy with the higher nominal interest
rate, since only a small amount of the difference
in interest returns can be offset by changes in the
exchange rate. In the process, the increase in the
supply of loanable fupds.inthe ecoQomywitn
higher interest rates and the corresponding de-
crease in the low interest rate economy tends to
bring about an equalization of nominal interest
rates. Because the system offixed exchange rates
holds together only if price levels at home and
abroad are notallowed to get out of line with
one another, rates of inflation at home and
abroad tend to be similar also. This produces a
tendency for an equalization of real interest rates,
or nominal rates adjusted for inflation, as well.
Under a system of flexible exchange rates, which
characterizes most major currencies since 1973,
there still is a strong tendency for capital flows to
equalize real interest rates athome and abroad
over the long run. But the process is less direct
and may not be observable in the short to me-
dium run. Even when there are no institutional or
governmental barriers to the international flow of
capital, two elements tend to work against the
equalization of real interest rates at home and
abroad under flexible exchange rates: (1) ex-
pected changes in exchange rates, and(2) pre-
miums in interest rates to compensate for the risk
of unexpected changes in currency values.
Under flexible exchange rates, if real interest
rates are higher at home than abroad, then a cap-
ital inflow tends to occur, just as in the fixed rate
case. But the capital inflow pushes up the value
of the homecurrency at the same timethat it
adds tothe supply of loanable funds at home.
'vVhether national real interest rates are fully
equalized by this process depends in part upon
expectatiolls aboutthe future value ofthe real ex-
change rate. If investors believe that the upward
pressure on interest rates and the exchange rate
in the home country is temporary, they will be
willing to bring in capital only up to the point at
which the expected future depreciation in the
real value ofthe home currency just offsets the
difference in real interest rates, except for any
differential due to a premium to compensate for
exchangerate risk. As a result, variations in the
pressures on interest rates at home and abroad
produce varying differentials in real interest rates.
These are proportional to expected future changes
in the real exchange rate towards a longer run
equilibrium. Evidence of the importance of this
expectational factor is thatmovements in real in-
terest rate differentials have been significantly
associated with movements in real exchange
rates (Throop1993).
The importanceofpremia for exchange rate risk as
an additional factor contributing to divergences
in realjnterest rates is suggestedby evidence
from ~urveys ofmarket expectationsoffuture ex-
change rates. If currency risk premia were small,
we wouldexpectfairlysmall differences in antic-
ipated returns on comparableassets calculated
using survey data as a measure ofexpected ex-
change rate changes. ButPigott (1993-1994)
shows thatthis is notthe case. Therefore, chang-
ing currency risk premia probably also contribute
to variation in differentials between real national
interest rates. Unfortunately, empirical studies to
date have had little success in isolating the fun-
damental economic factors that tend to cause
changes in these currency risk premia.
Empirical evidence
To determine the extent to which U.S. real in-
terest rates tend to be equalized with real rates
abroad over a longer run, a simple dynamic
model (an "error correction" model) was esti~
mated for the period offuily integrated financial
markets since the early 1980s (Throop 1994). Fig-
ure 2 shows the effect on the differential between
the u.s. and the trade-weighted foreign real
short-term interest rate of a 1 percentage point
shock to the U.S. rate, and Figure 3 indicates the
effect on the same differential of a 1 percentage
point shock to the foreign rate. The shaded areas
indicate a 95 percent confidence interval around
these estimated "impulse-response" functions
based on the observed distribution of errors in
the historical sample.
A positive shock of 1 percentage point to the u.s.
rate is estimated to raise the u.s. rate byclose to
1 percentage point, but to havelittle effect on the
foreign rate. Asa result, the estimated response
of the U.S. minus the foreign interest rate to a 1
percentage point shock to theUS. rate is not sig-
nificantly different from 1 percentage point and is
significantly different from zero over a period of
up to 16 quarters (Figure 2). (A zero response
would correspond to the case of an equalization
of interest rates, either bythe u.s. rate falling or
the foreign rate rising sufficiently after the shock.)
Similarly, Figure 3 indicates that the response of
the differential to a 1 percentage point shock to
the foreign rate is not significantly different from
minus 1 percentage point and is also significantly
different from zero. Thus, shocks to either real0.0
Figure 2
Effect ofShock to u.S. Real Interest Rate on
the Differential
Percent
Figure 3
Effect of Shock to Foreign Real Interest Rate on
the Differential
Percent
Adrian W. Throop
Research Officer
interest rate have close toa one-to-one effecton
the differential, with no signifitanttendencyfor
this effect to die out over 16 quarters. Moreover,
a further statistical test indicates thatin.the long
run, there has been no significant tendency for
real short-term interest rates at home and abroad
to move in the same direction during the period
offully integrated financial markets.
Conclusion
Since the early 1980s, national financial markets
in the u.s. and other major countries have been
fully integrated, in that they essentially operate
without government-imposed barriers tothe in-
ternational flow of capital. Yet, we have shown
that the responses of U.S. and foreign real interest
rates to one another have been extremely weak.
This is not surprising. Under a system offlexible
exchange rates, national real interest rates can be
kept apart for extended periods oftime by time-
varying expectations of changes in exchange
rates and varying premia for bearing exchange
rate risk. As a consequence, U.S. and foreign
central banks have been able to influence their
domestic interest rates quite independently from
the influence of interest rates abroad, despite a
high degree of international integration of finan~
cial markets.
8 10 12 14 16
Quarters
6 4 2
Throop, Adrian W. 1994. "International Financial Mar-
ket Integration and Linkages of National Interest
Rates:' Federal Reserve Bank of San Francisco
Economic Review (No.3, forthcoming).
____. 1993. "A Generalized Uncovered Inter-
est Parity Model of Exchange Rates:' Federal
Reserve Bank of San Francisco Economic Review
(No.2) pp. 3-16.
Pigott, Charles. 1993~1994. "International Interest
Rate Convergence: A Survey of Issues and Evi-
dence:' Federal Reserve .Bank of New York
Quarterly Review (Winter) pp. 24-37.
References
6 8 10 12 14 16
Quarters
4 2
-1.0
-2.0
-0.5
-1.5
-2.51
-3.0
-3.5 1-r.....,-~r-T' ........,.-T"""T-..-.-T"""T-..-,.-'r-1
MONETARY POLICY OBJECTIVES FOR 1994
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Index to Recent Issues of FRBSF Weekly Letter
DATE NUMBER TITLE AUTHOR
2/11 94-06
2/18 94-07
2/25 94-08
3/4 94-09
3/11 94--10
3/18 94-11
3/25 94-12
4/1 94-13
4/8 94-14
4/15 94-15
4/21 94-16
4/29 94-17
5/6 94-18
5/13 94-19
5/20 94-20
5/27 94-21
6/10 94-22
6/24 94-23
7/1 94-24
7/15 94-25
7/22 94-26
8/5 94-27
8/19 94~28
Stock Prices and Bank Lending Behavior in Japan
Taiwan at the Crossroads
1994 District Agricultural Outlook
Monetary Policy in the 1990s
The iPQ Underpricing Puzzle
New Measures of the Work Force
Industry Effects: Stock Returns of Banks and Nonfinancial Firms
Monetary Policy in a Low Inflation Regime
Measuring the Gains from International Portfolio Diversification
Interstate Banking in the West
California Banks Playing Catch-up
California Recession and Recovery
Just-In-Time Inventory Management: Has It MadeaDifference?
GATS and Banking in the Pacific Basin
The Persistence ofthe Prime Rate
A Market-Based Approach to CRA
Manufactllring Bias in Regional Policy
An "Intermountain Miracle"?
Trade and Growth: Some Recent Evidence
Should the Central Bank Be Responsible for Regional Stabilization?
Interstate Banking and Risk
A Primer on Monetary Policy Part I: Goals and Instruments
A Primer on Monetary Policy Part II: Targets and Indicators
Kim/Moreno
Cheng
Dean
Parry
Booth
Motley
Neuberger
Cogley
Kasa
Furlong
Furlong/Soller
Cromwell
Huh
Moreno
Booth
Neuberger/Schmidt
Schmidt
Sherwood-Call/Schmidt
Trehan
Cogley/Schaan
Levonian
Walsh
Walsh
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Linkages of national interest rates

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Linkages of national interest rates

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