Yesterday the Fed made fighting inflation tougher for emerging economy central banks

04/28/2011 12:20 pm EST


Jim Jubak

Founder and Editor,

The only open question, as far as the financial markets were concerned, in yesterday’s 12:30 ET announcement from the Federal Reserve was whether or not the Federal Reserve’s Open Market committee would change what’s known as the “extended period” language.

The committee said it would keep interest rates at their current extraordinarily low levels for an extended period—keeping the language the same and promising markets that they can count on the Fed to keep its benchmark short-term rates at 0% to 0.25% at least until the fall and probably until the end of 2011 or into 2012.

With that guarantee, traders were off to the races. The dollar, which held initially after the Fed’s press release, resumed its slide. Gold and silver both closed up in New York on the day. And continuing a very profitable strategy called the currency carry trade got the green light across Wall Street.

In this strategy traders borrow in countries with low interest rates and then use that money to buy in markets with higher yields. The trade is dangerous only if there’s a chance that the country where traders have borrowed will do something—like raise interest rates—that will raise the value of the currencies that they have borrowed. That would increase the amount that they have to repay on their loans.

Right now the carry trade has two very safe, very low yield currencies to borrow in—the Japanese yen and the U.S. dollar because the central banks in neither country are showing any inclination to raise interest rates any time soon.

The carry trade can be very, very profitable. Borrowing in yen and then investing in higher yielding assets denominated in New Zealand dollars has earned an annualized 305% from March 17 to April 26, Bloomberg calculates. Borrowing in U.S. dollars and then investing in assets denominated in Brazilian reais has returned an annualized 104% over the same period.

Yesterday's interest rate announcement from the Fed certainly won’t do anything to slow the carry trade or the flow of money into higher-yielding economies. That flood of cash will, of course, make it even harder for central banks in those economies to slow inflation.

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