QEII AND THE CARRY TRADE
The Fed is engaged in a second round of quantitative easing. This seems necessary given the low probability of any future fiscal stimulus. But what if the increase in liquidity just further fuels the carry trade? Interest rates are so low that investors are borrowing dollars and investing in emerging market economies to earn higher rates. As Japan used to be the borrowing center for the carry trade, now it is us.
Of course, the carry trade is less profitable if the dollar depreciates relative to other currencies. If QEII is effective in generating some extra inflation, and if investors expect this, this will dissuade carry traders. Those who think it will only lead to inflation or a dollar collapse must be predicting that no carry trade will take place. It is those who think it is too small or an ineffective instrument that must be expecting further carry trade.
Barry Ickes,
Professor of Economics at the Pennsylvania State University
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