Note prepared by the Specialist Adviser on uncovered
interest rate parity (UIP)
The interest parity condition lies at the heart of
most explanations of how interest rates affect the exchange rate.
There is, however, much misunderstanding of how it operates. It
is commonly used to predict how the exchange rate will respond
to a change in interest rates, but considerable care needs to
be taken to get this right. The use that appears to be made of
UIP by the Monetary Policy Committee as reflected, for example,
in the Minutes of May and June 1999, illustrates this.
The UIP condition asserts that domestic interest
rates will equal foreign interest rates once their return has
been converted to domestic currency, in other words, adjusted
for the expected rate of change of the bi-lateral exchange rate
over the period of the investment. This assumes that investors
are risk neutral and there are no capital controls. Risk aversion
will add a risk premium to this relation. UIP implies that the
expected rate of depreciation of the exchange rate (measured as
the domestic price of foreign exchangeie pounds per dollar
or euro) equals the interest differential between the domestic
and the foreign rate measured as domestic minus foreign. Thus
if the one year sterling interest rate exceeds the euro rate by
one percentage point, then sterling is expected to depreciate
over the next year by one percent unless interest rates change.
In other words, it predicts how the exchange rate is expected
to change in the future if there is no change in interest
The UIP condition does not say, as is sometimes thought,
that a one percentage point increase in the sterling rate will
cause a one percent depreciation of the exchange rate. In fact,
in response to the higher return on sterling assets there would
be a capital inflow and sterling would appreciate, not depreciate.
Moreover, this would happen instantly. The explanation for this
can also be found in the UIP condition.
A logical consequence of UIP is that the current
exchange rate can be expressed as the sum of all expected
future interest rate differentials, but measured now as foreign
minus domestic. Thus an increase in the current domestic interest
rate (or an expected increase in future rates) would cause sterling
to appreciate. The key to reconciling this apparent conflict
in the interpretation of UIP is that the increase in the interest
rate causes both the current and the expected future exchange
rate to appreciate, but the current appreciates more than the
future causing an expected future depreciation. This is the so-called
over-shooting implication of UIP in which an increase in the domestic
interest rate causes an appreciation of the current exchange rate,
and an expected depreciation in the future.
To illustrate, since its inception in January 1999
the sterling short interest rate has exceeded the euro interest
rate implying an expected future depreciation of sterling against
the euro, yet sterling has appreciated over this period. One
possible explanation is that a widening of the interest differential
has also made sterling assets more attractive.
The Minutes of the Monetary Policy Committee of May
1999 (para. 25) state that "The central projection assumed
that sterling's effective exchange rate would depreciate in line
with uncovered interest parity (i.e. interest differentials)."
This would only be correct, however, if interest rates were held
constant. This type of argument could not be used if the MPC
changed the interest rate. The Minutes of June 1999 (para. 32)
suggest an attempt to retrieve the situation in the statement
"Some members of the Committee were uneasy, on empirical
grounds, about the use of the Uncovered Interest Parity assumption
in the central projection, and for them sterling's persistent
strength was not a surprise." This view is consistent with
the long-lasting interest differential between United Kingdom
and euro interest rates. It would then, however, be at odds with
the argument that the recent strength of sterling was not due
to the MPC's interest rate policies.
It is a well-established fact that exchange rates
are very difficult to predict. This includes the precise response
of the exchange rate to a change in interest rates. It is clear
from the second implication of the UIP condition why this is.
If the exchange rate is the sum of current and all future interest
differentials then the weight given to the current interest differential
is likely to be quite small, and information (or rumours) likely
to affect future interest differentials could be far more important.
Arguably, uncertainty about future interest rates is the main
reason for the large error in forecasting the exchange rate, and
why a policy of exchange rate targeting is usually ineffective.
It follows that a temporary change in the interest
differential may have little effect. To have a significant impact
on the exchange rate, the current interest differential would
need to be thought a good predictor of future differentials. In
other words, the change in the current differential would need
to be thought long-lasting. For example, if the interest rate
change were expected to last a year, then the impact effect on
the exchange rate, and hence inflation, in the first quarter would
be four times larger than if it were thought to last only one
quarter. And if the increase were sustained for the whole year,
so that market expectations were correct, the cumulative effect
after one year would be ten times larger. Even if the interest
rate change were reversed after one quarter, the larger impact
effect would remain in the system.