International Capital Flows Alter U.S. Interest Rates

Thought it worth taking a brief trip away from Fed probabilities now that the market has reached a frenzied expectation that Fed eases arrive March 07. Not much to say about a frenzy except wait for facts to confuse the issue. The market rally does, of course, ease financial conditions and thereby mitigate the impact of 5.25% Fed funds. Market professionals also know that foreign capital flows have kept market interest rates low. Academe has caught up.

"International Capital Flows and U.S. Interest Rates (NBER Working Paper No. 12560)by Francis and Veronica Warnock conclude that the impact has been significant:

"Foreign official purchases of U.S. government bonds have an economically large and statistically significant impact on long-term interest rates. Federal Reserve credibility, as evidenced by dramatic reductions in both long-term inflation expectations and the volatility of long rates, contributed much to the decline of long rates in the 1990s. More recently, however, foreign flows have become important. Controlling for various factors given by a standard macroeconomic model, we estimate that had there been no foreign official flows into U.S. government bonds over the past year, the 10-year Treasury yield would currently be 90 basis points higher. Our results are robust to a number of alternative specifications."

There is also the ongoing expectation that we will need to keep interest rates high and the dollar strong in order to bribe foreign investors to keep buying our debt (finally an export in which we appear to have the greatest comparative advantage). We are at their mercy, so goes the common wisdom which always concludes with "How long can this go on?" Here's an answer -- "As long as the rest of the world wants to over save and under invest." And how long is that? Until it becomes politically necessary for a change. In other words, there is no answer.