The International Fisher Effect (IFE) is an exchange-rate model designed by the economist Irving Fisher in the 1930s. It is based on present and future risk-free nominal interest rates rather than pure inflation, and it is used to predict and understand present and future spot currency price movements. For this model to work in its purest form, it is assumed that the risk-free aspects of capital must be allowed to free float between nations that comprise a particular currency pair.
Fisher Effect Background
The decision to use a pure interest rate model rather than an inflation model or some combination stems from Fisher's assumption that real interest rates are not affected by changes in expected inflation rates, because both will become equalized over time through market arbitrage; inflation is embedded within the nominal interest rate and factored into market projections for a currency price. It is assumed that spot currency prices will naturally achieve parity with perfect ordering markets. This is known as the Fisher Effect, not to be confused with the International Fisher Effect. Monetary policy influences the Fisher effect because it determines the nominal interest rate.
Fisher believed the pure interest rate model was more of a leading indicator that predicts future spot currency prices 12 months in the future. The minor problem with this assumption is we can't ever know with certainty over time the spot price or the exact interest rate. This is known as uncovered interest parity. The question for modern studies is: Does the International Fisher Effect work now that currencies are allowed to free float? From the 1930s to the 1970s, we didn't have an answer because nations controlled their exchange rates for economic and trade purposes. This begs the question: Has credence been given to a model that hasn't really been fully tested? The vast majority of studies only concentrated on one nation and compared that nation to the United States currency.
The Fisher Effect vs. the IFE
The Fisher Effect model says nominal interest rates reflect the real rate of return and expected rate of inflation. So the difference between real and nominal interest rates is determined by expected inflation rates. The approximate nominal rate of return equals the real rate of return plus the expected rate of inflation. For example, if the real rate of return is 3.5% and expected inflation is 5.4%, then the approximate nominal rate of return is 0.035 + 0.054 = 0.089, or 8.9%. The precise formula is (1 + nominal rate) = (1 + real rate) x (1 + inflation rate), which would equal 9.1% in this example. The IFE takes this example one step further to assume appreciation or depreciation of currency prices is proportionally related to differences in nominal interest rates. Nominal interest rates would automatically reflect differences in inflation by a purchasing power parity or no-arbitrage system. (For related reading, see: What Is Purchasing Power Parity?)
The IFE in Action
For example, suppose the GBP/USD spot exchange rate is 1.5339 and the current interest rate is 5% in the U.S. and 7% in Great Britain. The IFE predicts the country with the higher nominal interest rate (Great Britain in this case) will see its currency depreciate. The expected future spot rate is calculated by multiplying the spot rate by a ratio of the foreign interest rate to domestic interest rate: 1.5339 x (1.05/1.07) = 1.5052. The IFE expects the GBP to depreciate against USD (it will only cost $1.5052 to purchase one GBP compared to $1.5339 before) so investors in either currency will achieve the same average return (i.e. an investor in USD will earn a lower interest rate of 5% but will also gain from appreciation of the USD).
For the shorter term, the IFE is generally unreliable due to the numerous short-term factors that affect exchange rates and predictions of nominal rates and inflation. Longer-term International Fisher Effects have proven a bit better, but not by much. Exchange rates eventually offset interest rate differentials, but prediction errors often occur. Remember that we are trying to predict the spot rate in the future. IFE fails particularly when purchasing power parity fails. This is defined as when the cost of goods can't be exchanged in each nation on a one-for-one basis after adjusting for exchange-rate changes and inflation. (For related reading, see: 4 Ways to Forecast Currency Changes.)
The Bottom Line
Countries don't change interest rates by the same magnitude as in the past, so the IFE isn't as reliable as it once was. Instead, the focus for central bankers in the modern day is not an interest rate target, but rather an inflation target where interest rates are determined by the expected inflation rate. Central bankers focus on their nation's consumer price index (CPI) to measure prices and adjust interest rates according to prices in an economy. The Fisher models may not be practical to implement in your daily currency trades, but their usefulness lies in their ability to illustrate the expected relationship between interest rates, inflation and exchange rates. (For more, see: Using Interest Rate Parity to Trade Forex.)