Hikes Affect the Dollar's Exchange Rate or Dream

If the Fed raises interest rates while other central banks maintain or even lower their interest rates, then the return on savings is more attractive in the U.S. than in other countries. Given this higher rate in the U.S., international capital should flow from other countries to the U.S., resulting in the dollar's appreciation.

Do the economic theory and data support this story? A standard textbook theory—uncovered interest rate parity—argues exactly the opposite: high-interest-rate currencies should depreciate.

Uncovered interest rate parity

U.S. short-term risk-free rate (say, the three-month rate) is higher than Japan's. An investor can borrow the money for three months in Japan, exchange the Japanese yen into the U.S. dollar and invest the money in a U.S. risk-free bond

The uncovered interest rate parity theory predicts an average expected return of zero for the carry trade investment strategy. For the zero return to occur, the positive gain from the interest rate difference must be offset by a decrease in the exchange rate, which implies a depreciation of the U.S. dollar. Otherwise, the carry trade can make a positive expected profit.