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Minyan Mailbag: More On Carry Trades

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The world's central banks are vehemently trying to create more credit against the deflationary weight of too much already out there.

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Prof. Succo,

I read your carry trade article but unfortunately I'm still scratching my head a bit. I think it would help if you explained what the economists call 'the transmission mechanism' of central banks.

My understanding of how it works is this: The Fed wishes to keep interest rates low, therefore they need to 'add reserves' to the banking system to increase the supply of deposits, thus banks don't have to pay depositors as much interest as they otherwise would and can therefore lend at lower interest rates. So they go ahead and buy U.S. treasury bonds from the banks with printed money. That printed money winds up as a deposit in the banking system, and banks need to lend it in order to earn some interest. They lend it to a consumer, who then buys imports from abroad, call it Asia. The next part is where i get confused.

Say a Chinese manufacturer now has the dollars from their sale to the US consumer, who borrowed it from the bank, who received it as a deposit from the seller of the US Treasury Bond to the Fed, who printed the money out of thin air. The manufacturer must pay some of his expenses in Chinese Yuan, so he goes to his friendly People's Republic Bank of China to exchange some U.S. Dollars for local currency. The PRBoC realizes that a sale of U.S. Dollars to purchase local currency (Yuan) would cause the Yuan to appreciate against the dollar, which of course they wish to prevent because they are maintaining a 'cheap currency' vis-a-vis the dollar. They intervene by buying the Dollars with, I assume, printed Yuan. Those Dollars are now in the hands of the Chinese Central Bank and rather than sit on them, they choose to buy some U.S. Treasury bonds to earn some interest. Thus the printed dollars recycle into the U.S. economy.

Now, just to review, the printed dollars went from:
The Fed who printed --> Commercial Bank who received the deposit --> U.S. Consumer as a loan --> Chinese Manufacturer as a purchase payment --> Chinese Central Bank as currency intervention --> U.S. Treasury Market as an investment --> Federal Government as a deficit spender.

Wouldn't this have the effect of causing inflation in the U.S. as well as China (both Central Banks have to print currency to execute the round trip)? And in addition, since the dollars ultimately come back into the U.S. economy as purchases of Treasury bonds issued by the U.S., how is this considered 'dollar sterilization?' As if the dollars were exported, mopped up by a foreign central bank, never to return.

Thus, when and if the PRBoC were to sell its U.S. Treasuries, wouldn't that result in big foreign DEMAND for dollars, thus a decline in U.S. liquidity and a sharp appreciation of the Yuan against the dollar?

Confused,
Minyan Damien

MD,

The only thing I found incorrect with your analysis is the word "DEMAND" about dollars, although the conclusion is correct. If the Bank of China sold its U.S. securities it would cause a rapid appreciation of the Yuan against the dollar precisely because of a sudden SUPPLY of dollars. If no one wants dollars, U.S. rates would have to rise rapidly to soak them up and liquidity would drop precipitously.

And yes, this whole process of printing causes inflation, the creation of credit. The world's central banks are vehemently trying to create more credit against the deflationary weight of too much already out there.

-Succo
No positions in stocks mentioned.

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