Do not raise interest rate, just yet!

The whole world is paying attention to today’s FOMC meeting which will be the first meeting since Janet Yellen became the Chairwoman of Fed. Fed Officials will be discussing many things, most hot topic is figuring out if there will be any change in interest rate or so called as forward guidance. Those two concepts are very important to the market, perhaps not only in the United States but for the rest of the World. In Fed’s website, they explained how forward guidance about the Federal Reserve’s target for the federal funds rate support the economic recovery and it is not difficult to believe what they say about effect of forward guidance is true. This is also the biggest reason why so many market watchers are eager to hear the result of today’s FOMC meeting. Since everyone is speculating and raising his opinions about the “right” time to raise interest rate, I shall give it a try to raise my own.

I say it is not the time to raise interest rate. There are two reasons behind my assertion. First, I believe that U.S. is still in the state of “BELOW NATUAL OUTPUT” in terms of our professor, Miles Kimball stated in his blog. Instead of looking at the Core Personal Consumption Expenditures Price Index (PCE) to represent core inflation, I pull out the “All-transactions House Price Index for the United States” from the Federal Reserve Bank of St. Louis data base, and came up this graph.

house price

The reason why I used house price index is that housing price is good indicator of inflation, because its relationship with Retail Price Index. Most often the core inflation is measured from RPI and not by Consumer Price Index (CPI); this is because CPI omits housing price. My observation tells me that changes of transaction in House Price Index are volatile yet, the important point I am making here is that changes are almost to sum up to zero. From the interpretation of volatility of housing price transactions, I conclude it is neither bubbled seriously nor deflated up to the point where people should be worried. Thus, inflation is not much of issued at this point.

Second reason is more trustworthy and academically sound since the idea came inside of a published paper from the National Bureau of Economic Research. WSJ article, Fed Shouldn’t Use Rates to Target Bubbles, Paper Says, sums up nicely about this newly published paper written by Anton Korinek and Alp Simsek from the John’s Hopkins University and I am going to do my best explaining it. Here is their main point:

“A common argument is that a contractionary policy that raises the interest rate in the run-up to the recent subprime crisis could have been beneficial in curbing leverage. Our model reveals that raising the interest rate during the leverage accumulation phase can have the unintended consequence of increasing leverage,” 

In this paper, when debts are forced to be repaid by higher amount, because interest rate has risen, market expects rise in interest rate will take off the inflation by some degree. But their data shows that it is not necessary be the case. Their argument is that “the size of the required intervention depends on the differences in marginal propensity to consume between borrowers and lenders during the deleveraging episode”. I think this very convincing, simply because if I was short of money repaying my debt because of this raise in interest rate, I might have been delayed my repayment. If millions of people do the same, I am convinced that this will “create unintended consequence of increasing household leverage and exacerbating aggregate demand externalities” as paper suggest. So, I would like to suggest not raising the interest rate until we are absolutely sure economy is perfectly healed.

3 thoughts on “Do not raise interest rate, just yet!

  1. psseo

    Very nice analysis of Fed monetary policy with lots of interesting citation. I also agree with your opinion that it is not the right time of raising interest rates and change the forward guidance. Many of arguments for monetary policy tightening is not so persuasive as we learn from the class of “contra John Talyor”.

  2. enjar

    Good post on raising interest rate.
    I have a question regarding your last sentence. In your opinion, what measures should be looked first to be sure that the economy is healed?

    I think the FED should (I believe they do) look at not only the unemployment rate but also labor force participation rate and, as you said, house price.

  3. jyyoo

    Very informative post! With unemployment statistics, it can be deduced that economy is not recovered fully. I agree that raising interest rate too early will be a problem.

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