The Federal Reserve’s stimulus boost has made carry trades more attractive and may raise capital flows to emerging economies and weaken the dollar, International Monetary Fund Chief Economist Olivier Blanchard said.
“It makes the risk associated with carry trades much smaller,” he said at an event at the London School of Economics late yesterday. “I think that risk has largely gone and therefore this makes carry trade more attractive. The implication for this implies more capital flows outside the U.S. and presumably some dollar depreciation.”
The Fed yesterday pledged to buy an additional $600 billion of Treasuries through June, expanding record stimulus and risking its credibility in a bid to reduce unemployment and avert deflation. That may increase expectations that the U.S. central bank will keep interest rates lower for longer, making investments in emerging economies using dollar-based funding more attractive, Blanchard said.
Still, the stimulus is “worth doing because I think the risks are so substantial,” he said. The “mechanical” effects of the so-called quantitative easing move “may not be very large,” though “the psychological effects may be larger.”
In a carry trade, investors borrow in low-rate countries to buy higher-yielding assets in expectation that gains made on the interest-rate differential won’t be offset by changes in exchange rates.
“There is a bit of hysteria about capital flows,” Blanchard said. “They are high but are not yet at pre-crisis levels.” Still, “some countries are faced with these large flows,” he said.
Blanchard also reiterated his forecast of global economic growth of 4 percent to 5 percent this year, correcting himself from an earlier erroneous estimate of 3 percent to 4 percent in a radio interview broadcast yesterday. The probability of the global economy contracting next year is about 2 percent and in the U.S. it is about 10 to 15 percent, he said.
“It’s clear what is needed to sustain growth in the U.S. over the coming decade is a shift in which consumers spend less, they have larger exports and a smaller current account deficit,” Blanchard said.