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Thursday, September 30, 2010

Policy Rule Gaps as Forecasts of Currency and Interest Rate Movements

Currency strategists at the Scotiabank are using “policy rule differentials” rather than simple “interest rate differentials” in a creative way to predict interest rate and currency movements. As reported in this Bloomberg piece Taylor Rule Gap with U.S. at 15-Year High Signals Rate Jump in Canada by Matt Walcoff and Chris Fournier, the policy rule differential is currently 275 basis points, while the current interest rate differential between Canada and US is only 75 basis points. Hence, Camilla Sutton and Sacha Tihanyi at Bank of Nova Scotia argue that the Canadian dollar and the Canadian interest rate will rise. Where do they get the 275 basis points? They estimate that the Bank of Canada is below their policy rule by 1 percentage point and that the Fed is above by 1.75 percentage points for a gap of 2.75 percentage points. Here are their calculations (scroll to page 13 of the September 10, 2010 issue). It is another example of how foreign interest rates affect central bank decisions, as I described in this recent post