Questions on finance in the U.S.A.

Finance

While highly inflated countries might have weak home currencies, this is absolutely not the case in the United States. The Bureau of Labor Statistics (2012) makes this very clear- core CPI is around 2.2%, when the Fed's target rate for inflation is between 1.7% and 2% (Spicer, 2012). That is by no intelligent person's definition "highly inflated." Because high rates of inflation are usually detrimental to economies (Investopedia, 2012), central banks tend to raise interest rates in response to higher inflation rates, as this can control inflation. When interest rates increase, the value of currencies will tend to decrease. Countries with higher inflation rates tend to see their currencies decrease in relation to the rates of trading partners with lower inflation (Van Bergen, 2012).

The inflation rate in the U.S. is 2.2%. The core CPI in Canada is 1.6% (Statistics Canada, 2012). This would indicate that the Canadian dollar should appreciate against the U.S. dollar, because that country has a lower inflation rate. As expected, the Canadian dollar appreciated against the greenback since January (graph courtesy of Oanda):

3. Normally, it would be expected that the nation with the one year interest rates that are higher would see its currency depreciated against any country with one year interest rates that are lower. The United States has seen its rates kept very low, near the zero bound, for the past several years. In contrast, Brazil's rates were ranging between 10 and 15% a year ago. This would indicate that the real should appreciate against the dollar over the past year. If we look at the exchange rates over the past year, we can see this has occurred.

According to Oanda, one year ago the real traded at 1.65 and today it trades at 1.75. This represents a change of 6%. The difference in the interest rates would have predicted a much greater change in the exchange rates between these two countries. This begs the question as to why the rates did not change further.

There are a few possible explanations for this discrepancy. The first is that the expected inflation in Brazil failed to material, and the second is that inflation in the U.S. was higher than expected. U.S. inflation is not high, but it is growing, whereas interest rates are not growing yet. In contrast, the Brazilian government's response to its inflation situation is more in line with what would be expected.