Interest Rate Parity

One of the models for making sense out of the levels of the currency exchange markets is the Interest Rate Parity Theorem. Supposedly the exchange rate will hold steady at some interest rate. Other things being equal, of course. Lately the Fed has been raising our interest rates at a measured pace of a quarter percent per meeting of the Federal Open Market Committee (FOMC). Last week (January 25) the Bank of Canada did not change their overnight interest rate at their meeting, but left it at 2.5%. This week the Federal Reserve raised ours to 2.5%. Thus, we have interest rate parity between the two currencies. The USD/CAD rate has been holding pretty steady at around 1.24 for the past week. Today the European Central Bank (ECB) left its rate unchanged at 2%. The perception is that the Fed will continue to raise interest rates here and the ECB will hold steady at 2% for the next few months. If there were no other factors involved, this would tend to strengthen the dollar vs. the euro. Since the euro has appreciated quite a bit vs. the dollar in the past quarter, these interest rate moves may restore stability in this important exchange rate. The relative calm in the currency markets over the past few days may be a result of an temporory equilibrium due to interest rate parity.