Federal Reserve Poking Game

Several weeks ago I wrote a blog post regarding interest rate and Fed’s next move. According to the Jan 28-29 FOMC meeting statement release, there was a mention of the new threshold on unemployment rate before raising the interest rate. Today, chairwoman Yellen suggests that she would stay on track with the original plan.

Let us wind back just a few weeks. The statistics from the Labor bureau showed that the job market had improve better and faster than had previously expected. Indeed, the job market had consistently done better since October, 2009, lingering around 10% down to 6.7% in this past February, but the output hadn’t been on par with this trend. So, when there was a talk about lowering the unemployment threshold, everyone seemed to be nodding their heads and adjusting their investment accordingly, or rather didn’t make any alterations from their previous holdings. Yellen’s statement today that interest rate may rise in six months time, really shocked the market, especially the treasury bonds. Bonds, which prices are determined by their expected value in 6 months time showed higher yield, signs of volatility in the market. S&P index and house builder index all showed dip signs.

To reiterate what I had said in my last blog post, it is very important for the Federal Reserve to be very clear about what they are going to do. To lay out some example in the past where expectation was important part of the economy, let us go back to 1970’s and 80’s. Although I am not a strong believer of the phillips curve for their meager support from real world data, I think the expectation augmented version of phillips curve rings truth in some sense.
Screen Shot 2014-03-19 at 9.01.35 PM (graph source here) 

We start from point A and the Fed uses expansionary monetary policy to ease the credit market, which increase spending in some sense and (according to the theory) raise inflation and reduce unemployment, moving to point B for the short run. Overtime, people associate this only as inflation and re-adjust to point C. Then, we could have the Fed use more expansionary measures to move from point D, raising inflation. But overtime, people re-adjust their expectation again. I could go on, but you get the story.

This in fact might have been the case in 1975 when Paul Volcker assumed office. He changed the Fed’s general policy of interest rate targeting through easy credit rating to inflation targeting.

Screen Shot 2014-03-19 at 9.17.40 PM (Graph source: FRED)

We see here, that there is a great hike in inflation in the late 70’s and then a huge drop in early 80’s. I blame this partly because people’s expectation on interest hike due to contractionary monetary policy did not adjust quick enough. People were in some sense spoiled (?) into thinking that easy credit would be granted again, and kept on spending. As hawkish Volcker was, that did not happen, so at the cost of high unemployment, Volcker was able to control inflation.

Now, Yellen has weakened some of the trust that Fed has built up since the time of Volcker. You might compromise into thinking that it is a rookie mistake in publicity, but there is no room for rookie mistakes in institutions like Fed. I am not to judge and say that hike in the interest rate is a bad thing or a good thing in the long run, but I will say that words of Fed should be very carefully thought out and should stick with what the words are saying.

One thought on “Federal Reserve Poking Game

  1. lippmanb

    I wrote about this in one of my blog posts too. Like I have said in a comment on another post, there is more to the decrease in the unemployment rate that what meets the eye. The labor force decreased in size, which would naturally create an illusion of more employment.

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