PIMCO's El-Erian says Fed fuels dollar "carry trade"

NEW YORK (Reuters) - The Federal Reserve will continue to foster a U.S. dollar-funded carry trade with its near-zero interest rate policy, Mohamed El-Erian, chief executive of Pacific Investment Management Inc., said on Wednesday,

The so-called carry trade refers to borrowing at low short-term rates -- in this case, in the U.S. dollar -- to buy high-yielding, long-dated securities in other markets. The intention is to profit from the rate differential, although rising short-term rates make this strategy riskier and less profitable.

Investors worldwide will keep borrowing dollars to buy assets including equities and commodities, fueling the risk of huge bubbles, given the Fed's stance, El-Erian told Reuters.

As expected, the U.S. central bank reemphasized its pledge to keep interest rates "exceptionally low" for an "extended period" as long as inflation expectations are stable and unemployment remains elevated.

Policymakers kept their benchmark overnight lending rate in a range between zero and 0.25 percent and conditioned its commitment on rates based on "low rates of resource utilization, subdued inflation trends, and stable inflation expectations."

"The simple message from today's announcement is that the Fed does not wish to rock the boat. I suspect many in the markets will interpret the Fed statement as a green light to pile onto the momentum trade in risk markets, further increasing the dollar-funded carry trade," El-Erian said.

Over the past year, the dollar has increasingly been at the epicenter of a so-called "carry trade." With interest rates effectively at zero in the U.S., global investors seeking higher returns are increasingly borrowing risk-free dollars to invest in higher-yielding currencies and assets, such as stocks, commodities, and emerging markets. These trades have kept putting pressure on the dollar as investors short the currency to invest elsewhere.

At Wednesday's close, the dollar was down against a basket of major trading-partner currencies, with the U.S. Dollar Index .DXY down 0.88 percent at 75.717 from a previous session close of 76.386. Overall, the dollar index is down about 6.7 pct year-to-date.

The Fed on the whole retained an upbeat assessment on economic growth. Policymakers said the U.S. economic activity had "continued to pick up" since its last meeting in September, but expressed concern that the recovery was likely to be muted.

"Household spending appears to be expanding but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit," the Fed's statement said. While still emphasizing risks, the Fed was a bit more optimistic than it was in September, when it had simply said spending was "stabilizing."

El-Erian said the Fed "welcomes the pick-up in economic activity and provides reassurance on inflation, but it does not address some of the more controversial issues that are increasingly on the mind of many." That includes the value of the dollar and "the risk of another asset bubble," El-Erian added.

"The Fed statement will, in the short term, add fuel for the dollar-funded carry trade."

(Editing by Kenneth Barry)