Why investing is so much fun, part 2

I have written in the past that I think one of the characteristics of economies and markets that make investing fun is that no law holds forever. As the world changes, the same action might have one kind of reaction one day and the opposite reaction the next. I have explained this based on the monetarist theory that an increase in the supply of money leads to inflation. Well, it did, until it didn’t. 

Now, I have come across something that looks even stranger. Ethan Ilzetzky and Keyu Jin from the London School of Economics looked at how the US Dollar and the economy in the United States and foreign countries react to an increase in interest rates by the Fed.

From the end of Bretton Woods in 1973 to 1989, an increase of interest rates by the Fed led to an appreciation of the US Dollar vs. foreign currencies and a decline in the industrial production in these foreign countries. This is how it should be and what economics textbooks predict. If the Fed hikes interest rates, demand for US bonds and other assets increases and the US dollar appreciates vs. other currencies. At the same time, higher interest rates in the US reduce demand for goods in the United States and since the United States is the world’s largest economy, this means that global demand declines as well and industrial production declines not just in the United States but in other countries as well. This effect is shown in the left-hand charts in the figure below which show the reaction to a one percentage point increase in interest rates in the United States in the Dollar exchange rate (top) and industrial production in countries other than the United States (bottom).

Reaction to a 1ppt interest rate hike in the US 1973-1989 (left) and 1990-2017 (right)

Source: Ilzetzky and Jin (2021). Top charts: Reaction of Dollar exchange rate (rising exchange rate = stronger Dollar). Bottom charts: Reaction of foreign industrial production.

But after 1990 the reaction reversed. An interest rate hike in the United States led to a weaker Dollar and rising industrial production in foreign countries. This is not how the world should behave and to be honest, nobody seems to know why this reversal happened.

First and foremost, the research established that this reversal is not driven by the financial crisis of 2008 and the introduction of unconventional monetary policy. It was already visible and statistically significant before 2008 and again established itself after 2010. 

One part of the puzzle may be explained by the rise of China and other emerging markets. If the Dollar weakens, emerging markets can borrow more in US Dollars and thus increase investments in their home countries. This should increase industrial production abroad. And with the rise of China and other emerging markets, this effect may have become so large since 1990 that it overpowers the reduction of demand from US businesses and households due to higher interest rates. But why should the Dollar weaken in the first place?

One theory is that if interest rates rise, banks become more risk-averse and reduce their lending as well as other activities that increase their balance sheets. This in turn, reduces the demand of banks for Dollars (or cash in general) that would be lent to customers. And this decline in demand for cash leads to a depreciation of the Dollar. If interest rates are lower, this effect might become stronger and since the general level of interest rates since the 1990s has been lower than in the 1970s and 1980s, This could theoretically explain the shift in Dollar reaction. However, I find this a very speculative explanation that doesn’t convince me. The model the authors build in their paper is extremely rudimentary and not realistic at all. 

So for now, I just accept the data as it is but don’t know why things have changed. But alas, that’s why investing is fun.