When central banks follow different policy paths, exchange rates may respond as investors reassess the relative returns on assets in each currency. But a higher interest rate does not guarantee a stronger currency, and the exchange-rate move is only one part of an international transfer’s cost. To decide what a transfer will deliver, compare live quotes for the exact transaction and focus on the amount the recipient gets after fees.
What central bank policy divergence means
Policy divergence is a difference in central banks’ current settings or expected future paths—for example, when one is expected to raise rates while another is expected to hold or cut them. Markets do not look only at the latest policy-rate decision: they also price expectations about future short-term rates and other conditions affecting returns.
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That distinction matters because exchange rates are asset prices. If investors revise one country’s expected rate path upward relative to another’s, they may reassess the currencies and assets involved. Benoît Cœuré, then a member of the European Central Bank’s Executive Board, described the conceptual link this way: “The implication is that the current level of the exchange rate should be a function of the average of current and future expected short-term interest rates.” BIS, November 6, 2017.
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How a policy shift can spill across borders
A Federal Reserve staff review describes three channels through which tighter U.S. monetary policy can affect other economies. The channels may work in different directions, so their combined effect depends on the circumstances. Federal Reserve, December 22, 2022.
Exchange-rate channel
A surprise increase in U.S. rates relative to foreign rates usually leads to dollar appreciation, according to the review. Changes in relative prices then affect trade, economic activity and inflation. The effect on a particular country depends on its trade links and other conditions.
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Domestic-demand channel
Tighter U.S. policy can slow U.S. demand and imports, reducing demand for goods and services from abroad. That can weigh on foreign output and inflation even if the exchange-rate channel is pushing in another direction.
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Financial channel
Higher U.S. longer-term yields can encourage international investors to rebalance toward U.S. assets, tightening financial conditions elsewhere. Dollar invoicing and dollar-denominated borrowing can amplify the effect: firms with dollar liabilities may face greater pressure when exchange rates and financing conditions change.
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The net spillover is not uniform across countries. Trade openness, currency mismatches, the role of the dollar in invoicing and borrowing, and other central banks’ responses all help determine which channel matters most.
Why rate differences do not predict a currency on their own
A Federal Reserve staff note published May 10, 2024 examined the 2021–2023 tightening cycle using survey and financial-market data. Across the full period, aggregate exchange-rate movements did not show a systematic relationship with changes in expected relative monetary-policy stances. In cross-sectional analysis, policy expectations were more clearly related to advanced-economy currencies; other factors tended to dominate emerging-market moves. The note also found that exchange-rate co-movement with broad risk-appetite measures was stronger on average than co-movement with market-implied policy-rate changes since early 2021, particularly during the dollar’s 2022 rise. These results describe that episode, not a universal rule or a forecast for a current currency pair. Federal Reserve, May 10, 2024.
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Some figures from the note illustrate both the possible relationship and its limits:
- In the note’s 2022 cross-section, its estimated coefficient implied about 1.7 percent currency appreciation against the dollar for each percentage-point increase in policy expectations relative to the U.S. counterpart for advanced-economy currencies. This is a sample-specific estimate, not a universal causal effect.
- The reported regression had an R-squared of 0.26, meaning substantial currency movement remained unexplained by that model.
- The note reports that the dollar appreciated about 5 percent against advanced foreign-economy currencies on average in 2021. That is a period-specific statistic, not an expected effect of divergence.
- In 2021, the Brazilian real depreciated about 7 percent against the dollar while Brazil’s policy rate rose about 6 percentage points; the Chilean peso depreciated about 18 percent despite rate increases. These examples show that other forces can dominate, not that rate rises cause depreciation.
A separate BIS study examined spillovers from seven advanced-economy central banks to 47 advanced and emerging-market economies. In its analysis, effects on long-term rates were more prevalent than effects on short-term rates, and financial openness was the strongest determinant of spillover intensity. Those findings are limited to the study’s design and sample. BIS Working Paper 757, 2018.
Independent reader supportYour contribution helps us test, update, and keep practical guides available for everyone.What this means for an international transfer
Wholesale foreign-exchange markets and consumer transfer quotes are different levels of analysis. In wholesale markets, covered interest parity links the cash interest-rate differential between two currencies to the difference between their spot and forward rates. In practice, a cross-currency basis can mean that borrowing through an FX swap costs more or less than borrowing directly in the cash market; liquidity, hedging demand and balance-sheet constraints can affect that basis. BIS, September 2016.
That wholesale pricing relationship does not establish the exchange rate or fees a bank or transfer service will quote a consumer. Nor do the cited studies quantify how much a particular policy divergence changes a household’s transfer cost. For a real transaction, compare current quotes for the same sending and receiving countries, amount, funding method and payout method.
Quick Recap
Compare the same transaction, not headline rates
- Check the final amount the recipient will receive after fees.
- Compare the exchange rate and any separately stated fee.
- Check delivery time and payout method, since quotes are only comparable when the transaction details match.
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