Why does the gap between two policy rates move an exchange rate?

An exchange rate is not the price of a thing. It is the relative price of two monies — and money pays interest. That single fact is the dominant medium-term driver of every major currency pair, and it is the right place to start.

The opportunity cost of holding the wrong money

Cash is never idle. Dollars sit in dollar money markets and earn the dollar rate; euros sit in euro money markets and earn the euro rate. Choosing which currency to hold is therefore also choosing which interest rate to earn, and the size of that choice is the differential, not either level on its own.

Take rounded illustrative numbers: dollar cash earning 4.50% a year, euro cash earning 2.50%. Hold $1,000,000 for a year:

1,000,000 × 0.0450 = $45,000

Convert to euros at 1.0800 dollars per euro (€925,926) and hold that instead:

925,926 × 0.0250 = €23,148, worth about $25,000 at an unchanged rate

The gap is $20,000 — exactly the 2.00 point differential. Everything in this course flows from that number: it is the reward for holding one currency instead of the other, and it is paid every day whether or not the exchange rate moves at all.

Why the level of the differential is not the signal

Here is where most people go wrong. A 2.00 point differential that everybody already knows about is already in the price. Nobody gets paid for reading a published policy rate.

What moves spot is a change in the expected path of that differential. Markets do not price today's policy rate; they price the whole expected sequence of rates over the coming years. That is why the two-year government yield of each country tracks currency moves far better than either central bank's current setting — a two-year yield is a compressed forecast of the next two years of policy.

Worked example. The US two-year yield is 4.30% and the German two-year is 2.60% — a spread of 170 basis points. An inflation release lands and the US two-year rises to 4.50%. The spread is now 190bp.

The arithmetic of the extra reward is small: 20 basis points a year, for two years, is about 40 basis points of additional cumulative carry. Mechanically, that alone justifies roughly a 0.4% move in the exchange rate. In practice the pair often moves more than that, because the same release also revises the expected path beyond two years and changes how much compensation investors demand for the risk. The differential is the anchor; it is not the whole story.

Real rates, not nominal ones

One refinement that matters. If a country's nominal rate rises purely because its expected inflation rose, nothing real has changed — the higher rate is compensating for money that will buy less. In theory, currencies respond to real rate differentials: nominal rate minus expected inflation.

Illustrative: 4.50% nominal with 2.5% expected inflation is a 2.0% real rate. 12.00% nominal with 9.5% expected inflation is a 2.5% real rate. The second country's headline rate is nearly three times larger and its real reward is barely different. Unit 2 turns that observation into a formal condition.

The honest limit

Rate differentials are the strongest medium-term regularity in FX, and they are still only a regularity. Currencies spend long stretches ignoring them entirely while politics, flows or panic take over — the later units of this course are largely a tour of those exceptions. Nothing here forecasts any currency's direction, and nothing here is advice.

In the data

"The policy rate" turns out not to be one number. The ECB's latest day is below: three rates on one date, the deposit facility rate (DFR), the main refinancing rate (MRO) and the marginal lending rate (MLF), which together form a corridor rather than a point.

Which of them belongs in a differential is a decision the data leaves entirely to you. Choose differently from whoever you are comparing against and your gap is off by the width of the corridor before any currency has moved.

Try it now

1. The Fed's latest day is below, and the ECB's three rates are above. Write down the differential in basis points. Neither side is one number: the Fed sets a band with a lower and an upper end 25 basis points apart, and the ECB has its corridor. State which end of each you used, because the choice moves the differential.

2. Below is EUR/USD over five years; the last three are the window for this exercise. Under it is every change in the two rates most people pair, the top of the Fed's band and the ECB deposit rate, dated by the day each took effect (measured 28 September 2026). Add a differential column to the table, Fed minus ECB in basis points, so the two series sit side by side.

3. Measure the two or three largest sustained moves in the pair on the chart. Describe, in one neutral sentence each, whether the rate differential in your column was widening or narrowing at the time — and stop there. You are looking for co-movement, not for a rule.