Throughout my nineteen years of real estate sales practice I have come to the realization that when it comes to interest rates setting real estate agents such as myself and their direct counterparts, the mortgage brokers, are typically afflicted by what could be termed as The Ptolemaic Syndrome: we believe to be at the center of the universe with Central Banks revolving all around us. This is probably due to the fact that both real estate agents and mortgage brokers are born with a marked sense of egocentrism Sigmund Freud would call it an incurable complex of superiority. The fact of the matter is, however, that the setting of interest rates involves more than domestic real estate markets, as large and as important as these may be.

Interest rates are the catalysts to the performance of real estate markets and, at the same time, they are pivotal to Central Banks monetary policies. To keep inflation low and stable, Central Banks aim to maintain a rough balance between demand and supply in the economy. When aggregate, or total, demand exceeds aggregate supply, the economy will push against its capacity limits - and inflationary pressures will tend to build over time. In this event, Central Banks will tighten monetary policy to dampen demand. Similarly, if there is too little aggregate demand relative to supply, the economy will operate below its capacity. If this gap between aggregate demand and supply were to persist, the projected trend of inflation would fall below target. The Banks would then ease monetary policy to stimulate demand and close the gap.

This is the reason why it is important to understand how developments in the world economies affect the balance between domestic demand and supply. Exchange rate movements tell something about economic developments that may be having a direct impact on aggregate demand. And the movements themselves have their own impact on aggregate demand, by changing relative prices for goods and services and by shifting demand between domestic and foreign-produced products.

There are two basic types of exchange rate movements - and no, I don't mean "up" and "down". The first type occurs when international demand for goods and services of one country increases, with the effect that its currency tends to appreciate. Conversely, when demand for goods and services decreases, its currency tends to depreciate. The second type of exchange rate movement reflects the rebalancing of portfolios in financial markets, which may have nothing to do with current demand for goods and services. One such example would be a flight of capital to so-called "safe havens" during an international financial crisis. Another example is a movement that relates to expectations of what might be necessary to do in order to resolve global imbalances, as in the case of the US foreign trade deficit.

As stated above, when global demand for goods and services rises, the demand for the currency also increases and the currency tends to appreciate. Similarly, when global demand for goods and services falls, so will the demand for the currency, which then tends to depreciate. But the exchange rate, by reacting to these changes in demand, also acts as a shock absorber. For example, when global demand for one nations goods and services weakens and its currency depreciates in response, the lower currency pulls down the relative prices of goods and services, making them more attractive in the international trade. And, of course, the opposite happens when global demand rises for goods and services; the increase in demand is dampened by the associated appreciation of the currency.

By observing the fluctuations in exchange rates and whether such fluctuations are the proximate result of either the first or the second type of exchange movements, Central Banks are then in a position to forecast aggregate demand for goods and services and, thus, set monetary policy. When aggregate demand falls, they will stimulate the economy by lowering interest rates. Conversely, when aggregate demand exceeds aggregate supply, the economy will push against its capacity limits and inflationary pressures will tend to build over time so that, therefore, interest rates will be increased. Of course, any shift in interest rates will necessarily affect real estate markets.

By monitoring the strength or weakness of a currency over time it is possible, therefore, to anticipate whether Central Banks will ease or tighten monetary policy by stimulating the economy through lower interest rates or by reducing the stimulus through higher interest rates. And, therefore, it will be possible to predict the impact that anticipated shifts in interest rates will have on demand for domestic real capital assets.

Luigi Frascati