[Revised] Do not raise interest rate

The whole world is paying attention to March 2014 FOMC meeting which will be the first meeting since Janet Yellen became the Chairwoman of Fed. Fed Officials will be discussing many things, and the hottest topic is deciding whether there will be any change to be made in short term interest rate and forward guidance of Federal policy. 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. 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 claim. First, I believe that U.S. is still in the state where “output is BELOW NATUAL OUTPUT” in terms of our professor, Miles Kimball, stated in his blog. In order to show that U.S. economy is really in the below natural output, Professor Kimball suggests to analyze the “core inflation rate” of economy. In a search for valid core inflation indicator, I chose to look at the All-transaction House Price Index for the United States from the Federal Reserve Bank of St. Louis data base, instead of looking at the Core Personal Consumption Expenditures Price Index (PCE) which is also a strong and commonly used indicator for core inflation.

house price

The reason why I used house price index is that I believe housing price is good indicator of what I would like to call “sensible inflation”, because of its close 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 from the graph tells me that changes of transaction in House Price Index are volatile yet, the important point I am making from this is that their logarithmic changes are almost sum up to zero. From the interpretation of volatility of housing price transactions, I conclude that economy is neither bubbled seriously nor deflated up to the point where people worries like it is the end of the world.

Second reason is that increasing household debts harms stabilizing economy. A WSJ article, Fed Shouldn’t Use Rates to Target Bubbles, Paper Says, sums up nicely about a newly published paper written by Anton Korinek and Alp Simsek from the John’s Hopkins University supporting that mere increase in interest rate does not take care of all the business which market expects it to do. I am going to do my best explaining it. Here is their main point:

The size of the required intervention depends on the differences in marginal propensity to consume between borrowers and lenders during the deleveraging episode. In our model, contractionary monetary policy is inferior to macroprudential policy in addressing excessive leverage, and it can even have the unintended consequence of increasing leverage.

Closest and relevant reasoning that I can link the paper with my claim comes from the section 6.2. Researcher’s model suggests that raising the interest rate does not decrease all the leverage of economy when higher interest rates creates a temporary recession for borrower since increasing interest rate is great burden to borrower. Moreover, they argue that the wealth is transfer to lender from borrowers by greater amounts which put borrower more less fortune. Including these two sounded assumptions, they showed that this can overturn the conventional effect which states a rise in interest rate can deflate economic leverage. They recognize that raise in interest rate can take off the “beer goggle” from investors by discouraging desirable return rate, and also be effective reducing asset bubbles. However, it would not be the same case in house hold deleveraging scenarios. And I totally agree with this paper.

If I was short of money repaying my debt due to rise in interest rate, I might well have been delayed my repayment. Millions of people would do the same, so 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 just because we are worried about asset bubbles and inefficient investment booms until we are absolutely sure economy is perfectly healed. Catch asset bubbles by imposing strong macroprudential regulation and leave poor house holders for now.