I received an email from Kelvin L who wrote:
How are interest rates related to inflation and correlated with Quantitative Easing (QEs) in the US?
Based on my understanding, the increase of interest rates will increase the currency strength while an increase in inflation will decrease the currency strength.
Then why does a country like the US want to maintain its interest rates when inflation is on the rise?
How do QEs come in and ease the situation?
When there is an easing situation, won’t there be more money circulating in the market and weaken the currency? The US isn’t an export-oriented country, so does the weakening of the US dollar will do any good?
Your general understanding is correct, that is
- increase of interest rates = increase of currency strength
- increase of inflation = decrease of currency strength
However, there are other factors to consider as well, especially in the case of the US.
The US is still recovering from their financial crisis for the last 3 years. Although there are good data coming out in the last few months, the US Federal Reserve remains cautious about the outlook of their economy by declaring the implementation of QE3 if necessary.
Inflation is a delicate issue; too much or too little inflation is not good for a country. If there is too much inflation, the people of the country will suffer as their disposable income becomes reduces because the prices of goods are rising too fast. If there is too little inflation, that means the economy of the country is not growing at a desired rate.
At this present moment, an increasing inflation rate is good for the US, as they are recovering from their financial crisis.
You are correct to say that when there is QE, there will be an increase in the amount of currency circulating in the market thereby reducing its value. This is true for most countries except for the US. Reason being, the US is the largest economy in the world, so if their economy is failing and requires QE, the world views it as a world crisis instead of just a crisis in the US alone. Money will flow to physical assets like Gold, Silver and safe-haven currencies like the US dollar itself. This is the reason why after QE2, the US dollar actually strengthened.
It is true that the US isn’t an export-oriented country, for now. It is their intention to increase their exports, because that is the only way they could repay the money that they owe to the world. In order to facilitate their exports, they need a weaker US dollar so that more countries can afford their goods.
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