Last week, we had a class discussion on yield-curve and perspectives on the interest rate. It started by reading a NY times article on 12/28/05 - Shares Plunge as Shift in Treasury Market Stirs Concern. That was when the yield curve first inverted (technically). We talked about the difference on the interest rate perspective (if any) between now and then. Here is the comment I made:
One main function of the FED is to adjust economy activity through adjusting over night interest rate. The higher is the interest rate, the higher is the borrowing cost, and less capital is flow into the economy. Yield curve reflects the supply and demand of bond at different mature terms. Rising interest hurts long term bonds, therefore when expect further interest raise, the long term bond yields raise, results larger yield different between long term bonds and short term bonds. When investors anticipate FED to cut interest which is beneficial to long term bonds, the demand on long term bonds drive the yield down, the yield difference between long term bond and short term bond diminished. When the long term bond yield is so low that it is less than short bond, the curve becomes inverted. Since banks profit from the positive interest difference between short term(loan) and long term(deposit), inverted curve will make it hard to get loan. Therefore, inverted curve result contraction in economic activities, and often see as a forecast of recession.
The low interest rate of 2001-2004 has been main factor that pull the US economy from the last recession, The low interest rate also results the latest housing boom market which many see as a bubble. After 13 consecutive interest rate, at the end of the 2005 when interest rate is at 4.25%. At that time, as indicated in the reference articles, many saw the interest rate raising phase is about to end and FED would cut the interest rate in the near future. That was the first time when the yield curve first became inverted. However, contrary to many people’s expectation, FED increased interest four more times instead of once, brought interest rate to 5.25% by mid of 2006, and left the rate at the level for a whole without indicating an interest rate cut is expected in the near future. Since the article published, the yield curve has been generally flat with some period of inversion. It indicated that the investors were continue to expect interest rate cut. It was until recently when the interest rate return flat but generally normal, which indicate investors are less expecting interest rate cut in the near future, even expecting an rise interest.
That is a truly surprise, and many people are worrying the high interest rate is hurting the economy, especially the housing market, which has been main driven force for the economy. The reason of such change in expectation lies in the other main function of the FED, which might be more important than the first one, that is maintain the value the US currency at a reasonable level, and control inflation. Since the US economy has been running on large deficit at country level, government level (and at individual level), it largely relies on borrowing from foreign investors and countries through new bond issues. The borrowing has been accumulated to such a high level that further issues of bond might not be absorb as before, which put more pressure on the US dollar. Also major US debtors such as China and Japan also have very low interest rate and are expecting to raise their interest rate. Such interest raise could draw capital out of the US economy if the US is to cut its interest rate. Comparing protecting the economy from a slow down, maintaining the US currency definitely has higher priority, therefore interest rate cut is not likely in the foreseeable future and it wouldn’t be a surprise to see interest rate continue to rise.
3 comments:
Last week we were asked to discuss a presentation made by the president of New York Federal Reserve Bank, Timothy F. Geithner, regarding some perspective of US monetary policy(http://www.newyorkfed.org/newsevents/speeches/2006/gei060111.html). From reading the presentation, and related articles, I feel I have a better understanding now on the US monetary policy, and its relationship with asset prices. As stated clearly in the presentation, “asset values should be neither a target nor a goal of monetary policy”. Only when asset value movement result impacts on the goals of monetary policy, it could be taken into monetary policy consideration. Economic output and inflation are the direct target of the monetary policy. Continue on our last weeks discussion, we shouldn’t expect Fed will directly consider the housing price in its policy making process at current stage, since in their view, housing price change has yet created Fed’s concern on the impact on economic output and inflation.
As part of the reading, I found another interesting article (http://www.nber.org/books/assetprices/meyer6-28-06.pdf) written by Dr. Laurence H. Meyer (http://wc.wustl.edu/Meyer_Forum/LHM_Bio_WU.pdf) which covered the topic from another perspective. Dr. Meyer was a FED governor from 1996 to 2002 and an influential member of FOMC. According to Dr. Meyer, such monetary policy guidance on asset values was encouraged by former Fed Chairman Alan Greenspan, and supported by current Fed Chairman Ben Bernake. However, Dr. Meyer criticized this his called “indirect approach” on asset price. He thought the policy played an important role on the equity bubble in the late 1990s. (He didn’t comment if he thought there is a housing bubble in the article). He argued that the Fed’s policy maker should be proactive, and take “Leaning against the bubble” approach in monetary policy making process, when the policy makers see there is a bubble in formation (such as equity or housing price). In his view, instead of loosing interest in 1998 after the Asian financial crisis and the implosion of LTCM, Fed should have tightened interest. The action resulted the equity bubble in 1999. Apparently, Dr Meyer’s opinion hasn’t been accepted at the main stream Fed policy, I suspect that’s the main reason Dr Meyer didn’t earn his tutorship as a Fed Governor.
I believe Fed policy makers job is more important and difficult than the policy makers in the Congress, and I don’t think I have the knowledge to judge which approach is better. However, I still leaning toward in favor of Dr Meyer’s opinion. I think assets bubbles in the long run do harm economic growth and socioeconomic stability. Also, I feel the indirect approach might lag behind the actual economic need in certain situations. For example, during the housing price expansion phase in the earlier few years, the increase in the housing asset values did not captured in the inflation rate, (I’m not sure if such asset increase was captured as economic growth either) therefore, monetary policy ignores such expansion. However, starting last year, when housing price are falling, due to buyers tendency of waiting and affordability, there were less buyers in the market and resulted an increasing in rent. Such increase is captured as growing inflation and put pressure on the monetary policy on tightening interest rate. The tightening would put further pressure on the housing market. Such counter-intuitive action really puzzles me. I hope with the study, I could understand better on the mechanisms of the approach.
pretty cool article ah.
by the way,AUV , are you still in the school? I thought you have worked ah
I have been working for a few years. I'm just using my company's benefit to work on a part time financial management degree. Right now, it's more for personal interest. I don't know if I could use it to change my career track in the future.
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