The zero interest rate fallacy: why raising rates is the only means of escaping the liquidity trap and restoring financial intermediation.

• Author: McKinnon, Ronald I.

The international dollar standard is malfunctioning. The Fed's reduction of the interest rate on federal funds to virtually zero in December 2008 (a move that was followed by other industrial countries) exacerbated the wide interest rate differentials with emerging markets and provoked world monetary instability by inducing massive hot money outflows by carry traders into Asia and Latin America. A "carry trader" is one who exploits interest rate differentials across countries by borrowing in low interest rate currencies m invest in currency domains with higher interest rates.

WHAT CAUSES WORLD MONETARY INSTABILITY?

Over the past decade, speculative money poured into higher interest rate emerging markets by carry traders has provoked domestic inflation as well as caused local currencies to be overvalued. When emerging market currency exchange rates are not tied down by official parities, their ongoing appreciation induces more hot money inflows. Neglecting the exchange risks involved, carry traders then see a double benefit: the higher interest rates in emerging markets combined with the capital gain as their investment currencies appreciate against the dollar.

To prevent or limit emerging market currencies from appreciating, emerging market central banks sell their local currency and buy dollars. In the presence of ongoing carry trades, however, emerging market central banks need to keep intervening to prevent continuing appreciation. This foreign exchange pressure leads to the violation of the theorem that a floating exchange rate gives monetary independence to central banks. From 2001 to 2011, interventions by central banks in emerging markets were massive: emerging market foreign exchange reserves increased sixfold--from $1 trillion to $7 trillion during the period. Although the People's Republic of China accounted for about half of this huge buildup, the combined interventions of large emerging markets--Brazil, India, Indonesia, and Russia, and a host of smaller ones--were equally important.

The sharp buildup of emerging market foreign exchange reserves with concomitant increases in domestic base monies was too big to be fully offset by sterilizing domestic money issue by selling central bank bonds or raising reserve requirements on domestic commercial banks. The resulting loss of monetary control in the emerging markets has led to inflation that is generally higher than that in developed market economies--and to worldwide bubbles in...