Remember, in a global economy with multiple currencies, or an economy with lots of price variation, the notion of a single “real interest rate” is tricky. The standard Fisherian story implies real interest rate near-neutrality across a wide set of expected monetary policy decisions. Say expected inflation goes up, the nominal interest rate goes up, and the real rate stays constant, except for a small liquidity effect.
But that story will not apply across the board. If, for instance, you live and consume in Jakarta, and you do not hold a PPP theory of the exchange rate, as indeed you should not, well, borrowing in dollars just got more expensive in real terms (with complicated qualifiers depending on forward rates which in reality don’t predict future currency movements so well). Or if the Fed lowers nominal rates, your real borrowing rate goes down, maybe by more or less the same percentage amount as the nominal rate went down for the Americans.
And if those Indonesians are optimistic about the performance of their own currency vis-a-vis the U.S. dollar, crikey! — their current real interest rates from dollar borrowing appear to be very low indeed. And if we are considering the individuals who hold disproportionate shares of non-USD currencies, almost by definition they are overly optimistic about the non-USD currencies.
And there are yet further complications which the nice weather today prevents me from outlining (what if those Indonesians are the marginal investors and they push around the market price for the Americans?)
All of which makes the Fed’s job much tougher. Here is the latest from Bloomberg:
Since the 2008 financial crisis, companies across emerging markets have been borrowing dollars and converting them into local currencies as part of a massive carry trade. This practice has helped U.S. dollar shadow banking go global as the effects of near-zero U.S. interest rates seep into all corners of the world economy.
That’s the main finding of a new report released Thursday by the Bank for International Settlements, an institution in Basel, Switzerland, known as the central bank for central banks.
The paper, co-authored by Valentina Bruno, a finance professor at American University, and BIS Economic Adviser and Head of Research Hyun Song Shin, serves as a follow-up to a report released by the bank in January that found firms outside the U.S. have borrowed $9 trillion in U.S. dollars, up from $6 trillion before the global financial crisis.
To be sure, we do not know how harmful these practices might be, or not. Here is FT coverage of the same:
By doing so companies become shadow banks, financial intermediaries moving dollars into local economies. Note, manufacturers do not have to explicitly act like hedge fund managers. Simply depositing funds with a local bank will help it to extend credit to other customers, while buying local commercial paper provides funds to domestic businesses.
The realisation prompts further questions. If it becomes more expensive to borrow in dollars, because say China fears prompt less dollar lending, will the corporate carry trade stop? Will it matter if it does?
I simply wish to reiterate that, no matter how many times commentators cite the low rate of price inflation, there are risks on both sides of the Fed’s forthcoming monetary policy decision.
Here is my much earlier post on monetary policy and the carry trade. Beware the too-rapid acceptance of the strict Fisherian equation! Once again, we do not live in a representative agent world and furthermore the multiplicity of agents speak a variety of languages and use a variety of currencies.