NCPA - National Center for Policy Analysis


November 27, 2006

In "International Capital Flows and U.S. Interest Rates," authors Francis Warnock and Veronica Warnock, both with the National Bureau of Economic Research (NBER), show that international capital flows have an economically important effect on the most important price in the largest economy in the world: the 10-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 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.

Source: Les Picker, "International Capital Flows Alter U.S. Interest Rates," NBER Digest, November 2006; based upon: Francis Warnock and Veronica Warnock, "International Capital Flows and U.S. Interest Rates," National Bureau of Economic Research, Working Paper No. 12560, October 2006.

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