International Capital Flows Alter U.S. Interest Rates

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.

There is a burgeoning literature on the impact of international capital flows on emerging market economies. For example, we have learned in recent years that in emerging markets foreign flows can result in a reduction in systematic risk and an increase in both physical investment and economic growth. These positive aspects of capital flows are tempered by the role of foreign flows in spreading crises.

In contrast, much less is known about the impact of capital flows on the larger economies of the world. And, until 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 show that international capital flows have an economically important effect on the most important price in the largest economy in the world, that of the ten-year U.S. Treasury bond. Specifically, the authors 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. In the summer of 2003, short-term interest rates were very low and inflation was well contained. 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.

The authors caution that although they subjected their data to many robustness tests, it is possible that their results overstate the effects of foreign flows. One might suspect that other factors not completely captured by their analysis were affecting interest rates over this period. Still, the facts they present are suggestive of sizeable effects and are likely accurate given that foreigners currently hold more than half of the U.S. Treasury bond market

-- Les Picker