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Economy Jan 27, 2012

Who benefits from Fed’s ultra-low US interest rate policy?

By Firstbiz Editors

Earlier this week, the US Federal Reserve announced that it intends to leave interest rates on hold until late 2014. It is the first time that the central bank projected that far ahead into the future. While financial markets cheered at the prospect of cheap money for the next three years, what does it mean for the rest of the world?

One, it means the outlook for the US economy is really, really bad. As an article in Business Spectator notes, there's a good chance that the US economy could be slouching towards a recession this year. Exports are slumping, capital spending is slowing and US consumers - who account for 70 percent of the economy - are in no mood to spend. In other words, the economy continues to remain very weak.

Interest needs to remain low to revive spending and investment. It also means that the former engine of global economic growth is still a long way off from purring back to life.

The only possible reason for the dollar to gain at the moment seems to be fears that things are much worse with the euro, which many analysts believe could blow up this year.Getty Images

Two, the US dollar could remain weak as a result of low interest rates. In addition, Chairman Ben Bernanke made it clear that the central bank would consider further monetary easing measures if required. Monetary easing increases the supply of dollars, further weakening its value.

The only possible reason for the dollar to gain at the moment seems to be fears that things are much worse with the euro, which many analysts believe could blow up this year. However, if those breakup fears start to recede, safe haven flows into the dollar will fall and everything will go back to being 'normal' again.

Three, the dollar 'carry trade' is likely to revive strongly. In a carry trade, investors borrow currencies such as the dollar and Japanese yen (where interest rates are extremely low) and invest those funds in high-yielding assets such as emerging market currencies or stocks. With the Fed committing to keeping interest rates low until late 2014, investors will be much more encouraged to engage in carry trades and bet on riskier assets.

Four, commodity and currency markets (especially in Asia) could see a surge as investors aggressively seek higher-yielding assets in the belief that US interest rates will be low for some time to come. Indeed, several commodity prices have surged on the back of the Fed's announcement. Brent crude surged above $110 a barrel, while gold soared to $1,734 an ounce, extending gains on the back of a weaker dollar.

Asian currencies, after being badly bruised in 2011, could also benefit from a weaker greenback and higher risk-taking by investors. The Indian rupee, for instance, has already climbed to a two-and-a-half-month high after falling more than 15 percent in 2011, mainly on the back of growing hopes that the economy could start mending this year and a cash reserve ratio cut by the Reserve Bank of India. Further quantitative easing measures from the US are almost certain to give the value of Asian currencies, including the Indian rupee, an extra bounce.

by Firstbiz Editors

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