Tag Archives: interest rate

Why is Wall Street Confused?

In my previous post I argued that the valuations on some of the growth tech stocks that have recently tumbled were overpriced and that a correction in the market was necessary. As this correction has occurred over the past week its affects have trickled down to the entire equity market. Today the Nasdaq dropped 1.3% and the total loss for the week was 3.1%. The S&P 500 and the Dow each dropped 0.9% as well today. (WSJ – Stock Bloodbath Hasn’t Hurt Other Assets)

Despite the recent selloff impacting all equities, riskier asset classes that are often negatively affected by the US stock market selloff reacted adversely in the market today. Whenever the stock market takes a negative hit historically oil prices have fallen as well. This trend did not occur this week as oil prices rose.

 

 

As you can see in the graphs depicted above the price of oil has not moved in correlation with the falling stock market. This trend was also witnessed in emerging markets. As the market fell today the South Korean Won hit a new five year high and the Brazilian Real hit another monthly high.

This unique market movement shows that the dominant market force is currently the Fed’s commitment to maintain low interest rates. This new Fed view comes as opposition to January’s consensus that rates would be immediately hiked due to the strength of the domestic economy. New thoughts about the Fed have caused investors to reinvest into emerging markets and thus create a capital inflow into emerging markets, thus strengthening emerging market currencies such as the Won and Real. The new belief regarding domestic interest rates is also the factor that has pushed up oil future prices.

The current trend in the market is a signal that many investors don’t see this broad equity selloff as a long-term correction. After a high yielding year for tech stocks, many investors are using this correction as an opportunity to cash in profits and diversify their portfolios. Furthermore, the changing treasury rates has created an overall market confusion that has left many investors trying to find ways to make their portfolios more risk-neutral until further guidance.

According to Palisade Capital Management CIO, Dan Veru, “Money isn’t leaving the market, it’s just being reallocated.” (WSJ – Nasdaq Closes Below 4000) With no specific news affecting the market it would appear that this is the current sentiment on the street. With this all being said it would appear as if Wall Street is stuck in a bit of confusion. As the Fed continues to give contradictory forecasts and China continues to waiver, it is difficult for anyone to really know what exactly is going on in the market. For this reason, we may start to see a lag period where investors move their portfolios in order to mitigate as much risk as possible.

Interest rate liberalization in China

Interest rate liberalization in China is long overdue, but steering the banking system of the second large economy in the world to a new direction is not a easy task. That’s why PBOC is hiring new brains to deepen their understanding of how to transform to a central bank more like other central banks, for instance, the Federal Reserve Bank of United States.

Ma Jun, until recently Deutsche Bank ‘s top China economist, was hired as the Chinese central bank’s new chief economist.   At a economic-policy session held by the PBOC and the IMF on March 27 in Beijing, he was proposing a plan to liberalize the country’s financial system within three years,  which he claimed will help the the country‘s economy reformation and sustain economic growth.

Currently, the PBOC targets a measure of bank credit called M2 and instructs China’s giant state-owned banks about their lending practices. For instance, the PBOC has told banks to halt loans to troubled real-estate developers and industries marked by overcapacity. By contrast, other central banks take a less direct role by setting benchmark rates that offer a guidepost to banks as they lend.

Mr. Ma said China should liberalize in steps in approximately three years. First it needs to establish a central bank-blessed interest rate(China’s interbank rate) that would set a benchmark for lenders. That would give China the equivalent of the U.S. federal funds rate. During a first stage of reform, the PBOC should keep its intentions about the interbank market quiet and target a broader measure of money supply, known as M3. If the interbank lending system stabilized, China could shift fully to a monetary policy where the PBOC would set the interbank market rate, and banks would be free to charge what they like for deposits and loans.But for such a plan to carry out, there are several caveats that must be factored in.

First of all, will PBOC be willing to give up control of lending by state-owned banks? Ma Jun must bear in mind the fact that it is much more easy for PBOC officials to send directives than to maneuver in a much more complicated market like Federal Funds Market.

Secondly, the biggest obstacle lies ahead for interest rate liberalization is what is known as the local government debt issue. lots of local governments of China have been facing the risk of default on the colossal debts borrowed from state-owned banks. These debts were used to fund local governments unplanned and outrageous investment in infrastructure in order to boost local GDP growth, which is closely tied to the evaluation of local governors performance.

If the interest rate freed up too quickly, there is fear that the interest rate will be too high and local government will have to borrow more new debts to payback old debts. The huge default risk will put China’s economy in a perilous situation.

Mr. Ma, taking into account the local debt issue, urged China’s local governments to boost the transparency of their operations and make bonds – not borrowing from banks and shadow-banking institutions—their main financial channel. “The advantages of doing so are to boost transparency of local government debt, to let the interest rates better reflect default risks, to solve duration mismatch and to diversify risks over-concentrated in the banking system,” he wrote.

The growing inability of local government to finance their debt is considered one of China’s biggest financial weaknesses. Unless there is a safer way to settle down local debt problem, I am afraid the interest rate liberalization agenda will be postponed.

 

(Revised) Owning Bonds Despite a Bearish Perspective

During the financial crisis, the Federal Reserve (Fed) cut the federal funds rate from above 5% to below 1% and has not raised rates since.

fredgraph_effectivefedfunds

As seen above, the grey shaded area represents the recent financial crisis. After reaching the zero lower bound (ZLB) in late 2008, the federal funds rate target has remained at 0.00-0.25%. With interest rates unable to go any lower due to the ZLB, the only way interest rates can move is upwards. The only question is – when will the Fed decide to raise rates?

Although I have been bearish on bond prices for some time, I have not traded on this perspective because I did not know when rates would rise. I am bearish on bond prices because bond yields and bond prices have an inverse relationship (ex. when interest rates rise, bond prices fall). As the economy improves, the moment that interest rates rise (and bond prices subsequently fall) approaches. Following the march FOMC meeting, I have come to believe that rates will rise in 2015. According to the Wall Street Journal, “If you expect lower returns from an asset class than it has provided historically, such as lower returns from bonds, then the math, and probably logic, would tell you to lighten up on bonds”. In order to lighten up on bonds, I would need to sell any bonds that I own. However, I do not own any bonds so I have considered shorting bonds instead through an exchange-traded fund (ETF) such as ProShares UltraShort Lehman 20+ Year Treasury.

Although this investment logic might be right, I have made a mistake by not having any exposure to bonds in the first place. According to the Wall Street Journal, “To be clear, the solution is not to eliminate bonds from your portfolio because they will still provide the very important diversifying benefit of cushioning your portfolio if the market should pull back”. Diversification is an important part of asset allocation that helps reduce the variance of expected returns through decreasing (and potentially eliminating) unsystematic risk from one’s portfolio. In a well-diversified portfolio, only systematic risk remains. On the one hand, systematic risk is correlated among all securities (i.e. macroeconomic news). On the other hand, unsystematic risk is uncorrelated among all securities (i.e. industry or company specific news). Traditionally, stock prices and bond prices have demonstrated a negative correlation. Adding bonds to my portfolio, which consists entirely of large cap U.S. equities, would offer me meaningful benefits through diversification. Recently, irregularities in the relationship between stock prices and bond prices (i.e. a positive correlation) due to quantitative easing might lead one to think that the benefits of diversification are lessened or eliminated. According to Burton Malkiel, “But note that even though correlations between markets have risen, they are still far from perfectly correlated, and broad diversification will still tend to reduce the volatility of a portfolio” (212). Although Malkiel was not referring to quantitative easing, he makes a useful point. As long as two securities are less than perfectly correlated (i.e. less than 1), then there will be benefits from diversification. With my portfolio consisting entirely of large cap U.S. equities, I could reduce the variance of my portfolio’s expected returns through diversification.

Despite my bearish view on bond prices, there are still ways for me to purchase bonds and gain the benefits of diversification. My bearish view on bonds is due to interest-rate risk. In this case, increasing interest rates will push down bond prices. If I wanted to still purchase bonds in order to diversify, then I could purchase bonds with short maturities. The shorter the maturity of a bond, the less it is subject to interest rate risk. This can be seen in the yield curve, which has a positive slope as maturities increase (and the credit rating remains fixed). Although the prices of short term bonds will still fall as rates rise, there will still be benefits from diversification.

As I attempt to adjust my portfolio’s asset allocation, I will consider both diversification and my bearish perspective on bonds. On the one hand, I will purchase bonds with short maturities. On the other hand, I will sell (i.e. sell short) bonds with long maturities. As a small investor, I will use ETFs in order to implement my strategy because it is more cost effective.

Owning Bonds Despite A Bearish Perspective

I enjoy following financial markets and implementing investment ideas in which I am confident will perform as expected. Recently, I have become bearish on bond prices. I am bearish on bond prices because interest rates are low and are expected to begin rising in mid-2015. Bond yields will rise as interest rates rise, which also means bond prices fall (i.e. bond yields and prices have an inverse relationship). As a result, I am thinking of ways that I can trade on this perspective. According to the Wall Street Journal, “If you expect lower returns from an asset class than it has provided historically, such as lower returns from bonds, then the math, and probably logic, would tell you to lighten up on bonds”. In order to lighten up on bonds, I would need to sell any bonds that I own. However, I do not own any bonds so I have considered shorting bonds instead through an exchange-traded fund (ETF) such as ProShares UltraShort Lehman 20+ Year Treasury.

Although this investment logic might be right, I have made a mistake by not having any exposure to bonds in the first place. According to the Wall Street Journal, “To be clear, the solution is not to eliminate bonds from your portfolio because they will still provide the very important diversifying benefit of cushioning your portfolio if the market should pull back”. Diversification is an important part of asset allocation to protect against the random walk of financial markets. For example, eliminating my exposure to bonds and only being exposed to stocks puts me at extreme risk of loss if the stock market declines. According to Burton Malkiel, “But note that even though correlations between markets have risen, they are still far from perfectly correlated, and broad diversification will still tend to reduce the volatility of a portfolio” (212). With my portfolio consisting of 100% large cap United States equities, I am subject to a significant amount of volatility. By adding some exposure to bonds, I might be able to reduce the volatility of my portfolio.

Despite my bearish view on bond prices, there are still ways for me to invest in bonds and gain benefits from diversification. My bearish view on bonds is due to interest-rate risk. In this case, increasing interest rates will push down bond prices. If I wanted to still purchase bonds in order to gain some exposure, then I could purchase bonds with short maturities. The shorter the maturity of a bond, the less it is subject to interest rate risk. This can be seen in the yield curve, which has a positive slope as maturities increase. Although the prices short term bonds will still fall as rates rise, there will still be benefits from diversification.

In addition to interest-rate risk, bonds are also subject to default risk that arises when a debtor fails to pay back the creditor. If a debtor is thought to have a high risk of default, then that debtor is charged a default risk premium and charged a higher rate of interest. If I wanted to still purchase bonds in order to gain some exposure, then I could purchase bonds with a higher risk of default. This is another way to still own bonds and decrease interest rate risk. In addition,  there will be benefits from diversification.

[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.

FED renews focus on its duel mandate

Wednesday, the FED dropped the unemployment rate as a benchmark for when to raise the federal funds rate.  It has hinted at doing this for since January, since the indicator has been decreasing due to discouraged workers dropping out of the workforce as opposed to being hired.  In its place, the FED has said it will use a more comprehensive approach, as it seeks to continue its accommodating monetary policy until inflation becomes a problem or employment picks up.

Not everyone shares this opinion, not even on the Board of Governors.  The president of the Minneapolis Federal Reserve Bank, Narayana Kocherlakota, was the lone dissenter in this past weeks FOMC meeting.  While he argues the new policy will lead to uncertainty, I question the viability of his alternative.

Central to his disagreement is the ambiguous nature of the FED’s guidance with respect to he interest rate going forward. Mr. Kocherlakota thinks that without a firm number to track, the FED’s commitment to its message won’t be taken seriously.  However, the FED has had to move its previous number (6.5% unemployment rate) because it was about to be realized, and the FED would like to see the economy closer to full employment before rates increase.  If the conviction of the FED rested on a deterministic number, then picking another on may seem as arbitrary as the first.

As an alternative, he suggests lowering the unemployment number to 5.5%, to provide a more determined target.  I feel that there is a problem with this.  Using data series from FRED, one of which is graphed below, it can be seen that the natural rate of unemployment in the short and long term is at or above 5.5% for the foreseeable future.  Using it as a guide provides no valuable information since one would think that the FED would try to step off the zero lower bound if the United States was at the natural rate of employment.  The FED needs a different metric in order to give it the leeway it needs.

alfredgraph

If a policy with a firm benchmark is desired to insure credibility and confidence, instead of the unemployment rate why not use inflation as a guide?  While some have argued to raise the target inflation, there are very rational reasons for why 2% was chosen, and nothing so extreme is needed.  Instead, the FED should say that the central bank will do what it feels is prudent to foster a return to the natural level of output while inflation remains below the targeted levels.

I feel that Inflation will play a central role in the FED’s decision to raise interest rates, whether it wants to put a number to it or not.  With inflation at its current levels, the FED has the price stability it needs.  Provided this price stability remains, the FED should do all it can to stimulate employment.  While a firm number would bestow confidence in markets, it can also cause exactly what we are seeing now when the economy reaches predetermined levels in unanticipated ways.  Based on past results, the United States should have a little more confidence in its Central Bank to handle its business.

The Fed Ties Interest Rate Raise to the Tapering Instead of Unemployment Rate

Following today’s Fed’s meeting, the meeting statement has been scrutinized by every word to word. Of course, the biggest headline news was the Fed’s move to drop the unemployment rate of 6.5% as a threshold rate for raising interest rate from its meeting statement. Not only are Fed watchers reading the statement literally word to word, but also some of the policymakers at the Fed worried that some paragraphs of the statement might stir the market to a wrong way. To be more precise, Minnesota Fed President Narayana Kocherlakota was the only voting member who voted against the Fed’s decision to remove the key number of 6.5% from the statement. He says that the a paragraph in the statement may signal the Fed’s weakness when it comes to reaching the long-term inflation rate of 2%. The paragraph he was referring to is following:

To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored [emphasis added].

It seems like the last sentence could have caused Mr. Kocherlakota to vote against the action because of it’s  possible inference of a lasting low inflationary period. As low inflation has continued since 2012, inflation expectation, also, hasn’t been reaching the goal of 2%. The expected inflation in 10 years is still lower than 2%. The following graph provided by the Cleveland Fed shows the market’s expectation of inflation in certain time horizons :
_cfimg-5903616803714210

Considering the low expected inflation in next few years, Mr. Kocherlakota’s worry of weakening the credibility of the Fed’s commitment to the 2% inflation is indeed valid. The Fed’s main goal thorough its forward guidance is to lower the expected interest rate for certain duration, but it’s another goal from which the FED is quite away from reaching it is to raise the inflation expectation, which in turn lowers the real interest  rate and boost investment.

Now let me interpret the Fed’s statement in my way. The WSJ posts an interesting post on how the latest Fed’s statement changed from last month’s. The following passage shows the change made in the statement from last month:

The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percentfor a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent, and provided that longer-term inflation expectations remain well anchored.

As we see from the change made in the statement, the Fed untied the possible date of raising interest rate from the unemployment rate and related it more to the Fed’s tapering process and its ending. Now, the Fed watchers should be giving more weights to the tapering process than before since it is now more related to the raise in interest rate.

This change could be progress forward for the Fed because as the tapering continues for at least throughout 2014, the market will have stronger signal of the Fed’s raising interest rate in near future. Even though then higher expected interest rate might seem worse for the economy, raised expected interest rate could actually induce more investment today, which is opposite to what one might assume. Because, the market will be surely knowing the coming of the raise in the interest rate in few months, firms should take advantage of the low interest rate today by borrowing and investing rather than postponing the investment project. This idea of surely known interest rate increase could create more investment is explained in my one of the previous posts.

 

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.

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.

(Revised) Malaysia Central Bank’s Decision

In ECON 411 –Monetary and Financial Theory class, we learned from Professor Kimball how effective negative real interest could be in order to stimulate the economy from the recession. By targeting long term inflation rate around 2 percent and setting nominal interest rate near zero, negative real interest rate can be achieved as shown by the Fisher Equation. US, Japan and many other countries used this monetary policy in order to stimulate the economy when financial crisis occurred in past years.

Wall Street Journal article (Rising Inflation in Malaysia Turns Up the Heat on Central Bank) points out Malaysia’s recent monetary policy and its outcome. Data which came out on Wednesday, February 19th showed that consumer price rose to 3.4% in January from a year earlier. Malaysia’s economy did grow at a strong rate past few years, and now Malaysia’s central bank is planning to raise the interest rate from 3.00% to 3.25 % as a measure of bringing the price level down. According to Wall Street Journal article (Malaysia’s Central Bank Stands Pat Again), Malaysia have been keeping its nominal interest rate at 3.00% for last three years. Due to its relative low interest rate compared to its inflation, Malaysia could achieve a fast economic growth, maintaining GDP growth rate of 4.7% in 2013 when many other countries suffered from the turmoil.

Malaysian government started to slow down its government spending, which could decrease domestic demand. Central bank’s decision of increasing interest rate could also reduce domestic demand, as people will save more money instead of spending it in domestic market due to higher interest rate. However, economists forecast that Malaysia can still achieve strong GDP growth of 5.0% to 5.5% this year, thanks to its strong export.

Malaysian central bank’s decision of increasing interest rate is a smart decision to hold inflation rate and curb dangers of overspending and control debt as well. When I read the articles and thought of Malaysia’s decision, I related this to US’s tapering of quantitative easing. US, although its unemployment rate is not meeting government’s goal fully, started to taper as US did achieve some economic recovery in recent years. “Tapering” is as important as “quantitative easing,” as economy could be over-stimulated and over-inflated and it could be very dangerous. Malaysia showed how effective “negative real interest rate” is, from its high GDP growth last year. If Malaysia can also show how they are able to control inflation and prevent “over-stimulating” the economy while keeping its economic growth strong just like economists have forecasted, it will be a good example of how negative real interest rate is a good, non-harmful stimulus for economic growth.