April 13, 2004

Follow the bouncing rates

I still don’t understand why, exactly, the Fed needs to raise interest rates in the coming year. Presumably, as more and more people find work, inflation will inevitably dust itself off and start to rise, but given the freakishly low rates at present, we should probably welcome a bit of inflation. Off the top of my head, the best rationale I can conjure up to explain the need for higher interest rates is that financiers who are paying for the federal debt by buying US Treasury bonds will eventually need a higher yield if we want them to keep shoring up our deficit. But if T-bills are, in theory, the lowest-risk investments in the world, why would anyone require a higher yield? Why can’t they be happy with the current state of things. A simple explanation no doubt exists; I just haven’t heard it.

(I’ve also heard that the Fed would raise interest rates to correct the unduly high ratio of debts to assets that most consumers and businesses are currently carrying. This seems like the most plausible explanation, but the media rarely brings up this point. Is that evidence for or against?)

Regardless, when Greenspan does get around to hiking up interest rates, we can expect emerging markets around the globe to take a hit, as The Economist explains:

Flat yields in mature markets make emerging markets look good. But there is more to it than that. The ample liquidity sloshing around in the rich world is also an invitation to enter into the so-called "carry trade". Carry traders borrow at low, short-term rates. They then invest the proceeds in higher-yield assets. Some simply buy long-dated American bonds. But the more adventurous look further afield, betting on richer-yielding emerging-market bonds with money borrowed at cheap rates in mature markets.

The problem is those cheap rates may not last much longer. Interest rates in Britain have already started rising. On Thursday April 8th, the Bank of England held rates steady at 4%, but it is expected to raise them another notch next month. When the Federal Reserve follows suit, the liquidity that lubricates the carry trade may dry up.
As the article notes, emerging markets have become so stable lately because investors have so much extra capital that they can afford to invest in (risky yet lucrative) developing countries. All that changes once interest rates rise. The main worry: when an emerging market can no longer count on foreign investment, its government is forced to finance a greater share of the country’s development. Then we end up with Mexico, circa 1994.

You know… the US is fighting two major wars and has a dying manufacturing base. Things will only get more volatile over time. So maybe it’s not such a good idea anymore for the rest of the world--especially the developing world--to rely so heavily on the Federal Reserve.
-- Brad Plumer 6:46 PM || ||