Why the Fed’s low interest rates are driving dollars abroad

BY Catherine Mann  December 18, 2013 at 10:29 AM EDT


Ahead of Wednesday’s Federal Open Market Committee announcement about whether the Fed will taper its monetary stimulus program, Making Sense interviewed former Fed economist Catherine Mann, now at the Brandeis International Business School. She doesn’t think the Fed will begin tapering this month. But when it does, she predicts the Fed could lower its purchases of assets in a nuanced way, perhaps lowering the amount of Treasuries, but not of mortgage-backed securities, it buys. In our continued conversation with Mann, below, she notes another particularity of the Fed’s quantitative easing policy — that keeping interest rates low on Treasuries has sent money abroad.

Catherine Mann: I think we have to remember that it’s not just the Federal Reserve out there buying Treasuries in the market place. There are private sector buyers and there are foreign buyers, and I think one of the most interesting things that that I’ve observed in some of the work that I’ve been doing is that foreign purchases of U.S. Treasuries have tracked quantitative easing very, very closely. So there’s a lot of cross border trade in U.S. Treasuries; lots of financial institutions use them as collateral. [There's a] tremendous increase in that cross border activity when the Federal Reserve is engaged in quantitative easing.

Paul Solman: So but what’s the implication of that?

Catherine Mann: The implication of that is that this is another indication of the extent to which the financial system is arbitraging the quantitative easing.

Paul Solman: But the one thing that people talk a lot about is if interest rates in the United States are low, then money will flow to other parts of the world and if interest rates go up (the Fed starts to taper), that’s having a negative effect on the inflow of money to other economies.

Catherine Mann: Oh yeah absolutely. I mean, there’s no doubt. Okay, so I’m an investor, and I want to maximize the yield on my portfolio, so I’m looking at my possible places to invest. I can invest in the U.S. stock market; that’s been a pretty good place to invest, but I might want to have some bonds in my portfolio as well. And I don’t want to buy any U.S. bonds because those interest rates are really, really low because of the quantitative easing program. So I start to look at buying bonds that have been issued by companies or countries around the world and those bonds have much higher interest rates than the bonds that I can get in the United States.

Paul Solman: Well they’re not higher in Sweden, they’re not higher in Switzerland, they’re not higher in Germany, they’re not higher in the U.K.; there are lots of places where the interest rates are even lower than in the United States.

Catherine Mann: But there are lots of places where the interest rates are a lot higher. Think of countries in Latin America, think of Africa, think of countries in Asia.

Paul Solman: Yeah, Greece, I mean you can always find somewhere where there’s going be higher interest rates cause there’s more risk.

Catherine Mann: So some of my cheap money that I get in the United States, I am going to send abroad and invest in bonds that are in high risk areas. Now, is the interest rate there compensating me for the risk? Well, that’s a legitimate question, but in terms of capital flows, in terms of money going from the United States to other countries, there’s no doubt that quantitative easing has led to more capital flows.

Paul Solman: You mean that financial institutions in the United States can borrow money cheaply because the Fed has kept interest rates so low, so it’s low for them too, and then they can take that money and invest it in riskier assets abroad?

Catherine Mann: Sure, why not? We have a global capital market — that’s exactly what you’d like to be able to do: take a very low risk, low return, cheap money environment, borrow here and then invest it in something that is hopefully going to earn you a higher return, and if that’s abroad, why not go there? Now we can ask whether or not those countries have effectively used the money, or whether it’s just gone into short-term hot money flows over there, that’s a legitimate question. And we did see that in May, when the first inklings of perhaps the tapering talk came out, there was a rush to bring the money back to the United States and that had negative consequences in a number of high risk foreign markets.

Paul Solman: But this raises the overall issue, it seems to me, of how important are the Fed’s activities given the huge size of the global marketplace? Isn’t it possible that interest rates in this country are low simply because there’s so much capital in the world that it’s looking for a safe place to invest, and therefore it rushes into the United States and interest rates go down regardless of what the Fed does?

Catherine Mann: That’s a legitimate question. I mean, the Fed is small, in terms of its buying compared to the rest of the world. And it is certainly the case that U.S. Treasuries are a small part of what is a huge global capital market if we think of the global markets of all those different kinds of stocks, all those different kinds of bonds and all those investors who have wealth. The Fed and U.S. Treasuries are a really, really small part of that, but the U.S. Treasury interest rate, whether it be the short-term interest rate, the five-year, the 10-year, that U.S. interest rate is the anchor for all these other financial instruments and financial markets.

And so it does matter what the Fed does when the Fed’s actions have an effect on the U.S. Treasury interest rate. … That anchor to the global financial market, whether it be stocks or bonds or companies or countries, that anchor of U.S. Treasury rates does affect all these other components of the global financial markets.


This entry is cross-posted on the Making Sen$e page, where correspondent Paul Solman answers your economic and business questions