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Friday, October 27, 2006

International Capital Flows and U.S. Interest Rates

What affect, if any, do international capital flows have on long-term interest rates within the U.S.?:

International Capital Flows Alter U.S. Interest Rates, by Les Picker, NBER Digest: There is a burgeoning literature on the impact of international capital flows on emerging market economies. ... In contrast, much less is known about the impact of capital flows on the larger economies of the world. ...[U]ntil recently, many market participants held the view that capital flows could not possibly affect interest rates in the United States.

In International Capital Flows and U.S. Interest Rates (NBER Working Paper No. 12560), authors Francis Warnock and Veronica Warnock ... ascertain the extent to which foreign flows into U.S. government bond markets can help to explain movements in long-term Treasury yields.

The authors address this issue at an important time. ... Over the course of 2004, the Federal Reserve began a well advertised tightening that raised short rates while economic growth strengthened and inflation picked up. Many market observers predicted an increase in long-term U.S. interest rates that would result in substantial losses on bond positions. However, long-term interest rates remained quite low, puzzling market participants, financial economists, and policymakers.

The authors find that foreign flows have an economically large and statistically significant impact on long-term U.S. interest rates. Their work also suggests that large foreign purchases of U.S. government bonds have contributed importantly to the low levels of U.S. interest rates observed over the past few years. In the hypothetical case of zero foreign accumulation of U.S. government bonds over the course of an entire year, long rates would be almost 100 basis points higher. Were foreigners to reverse their flows and sell U.S. bonds in similar magnitudes, the estimated impact would be doubled. Further analysis indicates that roughly two-thirds of the impact comes directly from East Asian sources. In addition, some of the foreign flows owe to the recycling of petrodollars, suggesting a mitigating factor that might be reducing some of the bite of higher oil prices. ...

    Posted by on Friday, October 27, 2006 at 12:09 AM in Economics, International Finance | Permalink  TrackBack (1)  Comments (25)

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