Serving the Quantitative Finance Community

 
User avatar
AlexRub
Topic Author
Posts: 9
Joined: August 23rd, 2015, 3:22 pm

Fed rate increase

December 24th, 2016, 8:30 pm

Hello!
I would really appreciate if someone can explain why people say that the Fed 'has to raise' interest rates at some point in time. I'm interested in economic explanation, that is, the mechanism that makes the raise a necessary step.
On the one hand, a raise in interest rates decreases the investment which in turn yields lower income for the economy. On the other hand, a raise in interest rates decreases inflation and creates a monetary policy tool for the future when the decrease in the interest rate will be necessary. But is that it? Or, perhaps, there is another reason for why an increase in interest rates could be beneficial.
Thank you!
 
User avatar
list1
Posts: 827
Joined: July 22nd, 2015, 2:12 pm

Re: Fed rate increase

December 25th, 2016, 12:17 am

Hello!
I would really appreciate if someone can explain why people say that the Fed 'has to raise' interest rates at some point in time. I'm interested in economic explanation, that is, the mechanism that makes the raise a necessary step.
On the one hand, a raise in interest rates decreases the investment which in turn yields lower income for the economy. On the other hand, a raise in interest rates decreases inflation and creates a monetary policy tool for the future when the decrease in the interest rate will be necessary. But is that it? Or, perhaps, there is another reason for why an increase in interest rates could be beneficial.
Thank you!
Increasing ir in a country depends also on the place of the country in the world economy though many aspects of the event are similar regardless of the country's role. The primary effect of the changing rate is expected dynamics of the FX rates and its effect on primary indexes. Next questions are expected cash inflow-outflow that economically expressed import-export and inflation-deflation effect.
Now increasing ir in general should depreciate currency but USD is still primary currency for trades in the world market as well as US bonds are primary securities for holding money surplus. We should make a decision about effect of the US rate increase on EUR and YEN then how would change the values of DJI and others. How would be changed the volume of the trades which represents surplus and demand on USD contracts and volume changes of US equity market. It will be possible that on short period all markets will get a negative fall following US drops. If for example China market will fall more significantly than US then market can push US market up. As far as US economy does not look sufficiently healthy  it might be second wave will push two countries down. Though there are many factors will effect on world economy dynamics and increasing rate on usual 0.25% might have significantly low effect on economic and finance of the world market. A real prediction always make some basic assumptions which also could be close or even incorrect in the real world. 
 
User avatar
AlexRub
Topic Author
Posts: 9
Joined: August 23rd, 2015, 3:22 pm

Re: Fed rate increase

December 25th, 2016, 12:39 am

Thanks for the answer. However, that's not exactly what I was looking for. What you wrote are possible ramifications of a rate increase.
Why Fed will have to increase the rate at some point? Why is this step deemed to be necessary? Because ... How would you fill in the dots in your answer?
 
User avatar
list1
Posts: 827
Joined: July 22nd, 2015, 2:12 pm

Re: Fed rate increase

December 25th, 2016, 2:23 am

Thanks for the answer. However, that's not exactly what I was looking for. What you wrote are possible ramifications of a rate increase.
Why Fed will have to increase the rate at some point? Why is this step deemed to be necessary? Because ... How would you fill in the dots in your answer?
Excess of USDs makes them ineffective for US economy growth. In classical situation to get money you need to produce and sell productions. In printing money or bonds then buying bonds back they are pumping  economy by money. A little low effective  productions do not lead to default or bankruptcy.
Increasing rate makes money more costly for moving business forward which is more necessary for real economy in contrast to rather virtual stability of economy we have observed last time. It is based on financial games rather than economy issue.   
Increasing rates does not actually necessary but the last years experience suggest that there is no changes in economy should be expected.
 
User avatar
AlexRub
Topic Author
Posts: 9
Joined: August 23rd, 2015, 3:22 pm

Re: Fed rate increase

December 25th, 2016, 3:47 am

Excess of USDs makes them ineffective for US economy growth.
The long-run growth is independent of the money supply (e.g., Solow growth model). The short-run growth does depend on the money supply, but an increase in IR reduces investment and thus the economy's output. From this point of view, it is an increase in IR that is ineffective for the US economy growth. Is there anything wrong with this argument?
Increasing rate makes money more costly for moving business forward which is more necessary for real economy in contrast to rather virtual stability of economy we have observed last time. It is based on financial games rather than economy issue.   
Increasing rates does not actually necessary but the last years experience suggest that there is no changes in economy should be expected.
Any connection to theory (e.g., IS-LM model)?
 
User avatar
list1
Posts: 827
Joined: July 22nd, 2015, 2:12 pm

Re: Fed rate increase

December 25th, 2016, 4:43 am

Excess of USDs makes them ineffective for US economy growth.
The long-run growth is independent of the money supply (e.g., Solow growth model). The short-run growth does depend on the money supply, but an increase in IR reduces investment and thus the economy's output. From this point of view, it is an increase in IR that is ineffective for the US economy growth. Is there anything wrong with this argument?

/// You couldn't state such definitely about  long growth because it is a composition of short-run. Otherwise it should be clear how long term of short terms growth eliminates dependence of money.
Instead of investment it is better use money supply notion and your conclusion is correct in general but for US bonds there is external market which invests in US bonds and in other USD contracts. Hence when  US rate increase the demand for US cash and bonds can increase too
based on  effect of US rate increased on other world. Hence it might be observed an effect of growth of US economy though there is no economy growth be observed.


Increasing rate makes money more costly for moving business forward which is more necessary for real economy in contrast to rather virtual stability of economy we have observed last time. It is based on financial games rather than economy issue.   
Increasing rates does not actually necessary but the last years experience suggest that there is no changes in economy should be expected.
Any connection to theory (e.g., IS-LM model)?
I am not sure that there exists a theory which deal with printing money and beside a particular role of US economy and its finance make situation especially particular and nonstandard. 
 
User avatar
Alan
Posts: 2958
Joined: December 19th, 2001, 4:01 am
Location: California
Contact:

Re: Fed rate increase

December 25th, 2016, 3:56 pm

My take. Very low or zero rates lead to various distortions in the banking system. If banks themselves earn essentially zero on their own short-term deposits, they want to make customers earn a negative rate -- i.e., pay them  for deposits. But, money market funds in the US cannot accommodate negative rates and, even if they could, it would lead to hoarding of cash. So, this argues for some nominal short-term rate at least high enough to i) prevent these distortions, and ii) keep the banks healthy, assuming the economy is generally expanding. 

Beyond that, if inflation greatly accelerates (for reasons unrelated to nominal rates), the fed should respond to that. Currently, inflation is somewhat "too low" from the fed's perspective. The fed says they want inflation to average around 2% per year, and it would seem gradually raising rates will partly make that a self-fulfilling prophecy. As to why 2% is some kind of magic number for inflation (instead of zero), I don't know. 

   
Last edited by Alan on December 25th, 2016, 4:46 pm, edited 1 time in total.
 
User avatar
list1
Posts: 827
Joined: July 22nd, 2015, 2:12 pm

Re: Fed rate increase

December 25th, 2016, 4:24 pm

My take. Very low or zero rates lead to various distortions in the banking system. If banks themselves earn essentially zero on their own short-term deposits, they want to make customers earn a negative rate -- i.e., pay them  for deposits. But, money market funds in the US cannot accommodate negative rates and, even if they could, it would lead to hoarding of cash. So, this argues for some nominal rate at least high enough to i) prevent these distortions, and ii) keep the banks healthy, assuming the economy can tolerate it. 

Beyond that, if inflation accelerates (for reasons unrelated to nominal rates), the fed should respond to that. The fed says they want inflation to average around 2% per year, and it would seem raising rates will partly make that a self-fulfilling prophecy. As to why 2% is some kind of magic number for inflation (instead of zero), I don't know. 

   
Alan, I agree with your point. But also if bank system holds a lot of money that from one hand support market trades keeping primary indexes high and on the other hand which does not involve in real economy the process of increasing interest rates can be delayed for a long time while selling bonds and its demand from other world is still stable.
I also have a feeling that inflation now does not directed of the market. Though looking at medical insurance and some other pricing changes one can conclude that inflation is quite observable responding on QE policy.
 
User avatar
DavidJN
Posts: 242
Joined: July 14th, 2002, 3:00 am

Re: Fed rate increase

December 25th, 2016, 10:29 pm

Following Alan's on-topic post. here is my very short list of why the Fed might think rates must rise.

1. Extremely low interest rates have created a situation of moral hazard by encouraging excess borrowing, particularly among those who normally would not qualify. High leverage is now rampant throughout the economy. Historically, balance sheet recessions were typically caused by highly levered corporations going down and the fiscal capacity of individuals and government provided the bailouts. Who has the wherewithal to fund the bailouts now when every sector is up to its eyeballs in debt?

2. Negative rates are inconsistent with the long-held belief that people should expect a positive return from investing. Given the finite nature of human life a logical fundamental principle used to be that to convince me to lend (i.e. to defer consumption) you should repay me more in the future. Explanations for the demise of this fundamental puzzle typically appeal to some kind of liquidity phenomenon, perhaps regulator driven (e.g. the requirement that banks hold considerable liquidity in the form of government paper). I suppose it is possible we've evolved into some kind of new world order where people now expect to lose money from safe investments. In any event the protracted period of low rates has certainly been an effective and legal way to transfer wealth from low risk tolerance savers to borrowers and speculators.

BTW, I think you might be putting way too much faith in standard economics theory. I think the the best way to think about our weird world these days is to think about twisted incentives created by governments, fundamental market problems and regulatory/legal capture. The simple fact that the financial business has consistently generated such a fat living should strongly suggest that it is inherently not a competitive activity, that much of economic theory I believe in.
 
User avatar
ppauper
Posts: 11729
Joined: November 15th, 2001, 1:29 pm

Re: Fed rate increase

December 27th, 2016, 7:49 am

there are several issues here
We used to laugh at the old soviet union with its 5 year plans for the economy, but that central planning is exactly what the fed does.
Why should interest rates be set by the banking cartel (aka the fed) rather than by the market?
My take. Very low or zero rates lead to various distortions in the banking system.
malinvestment, leading to the boom-bust cycle
2. Negative rates are inconsistent with the long-held belief that people should expect a positive return from investing.
lol, "long-held belief"
that brings us to the war on cash.
If I can earn 0% by keeping money in a shoebox under my bed, why would I pay a bank?
Unless you ban people from holding cash, which is the road several lands are going down
 
User avatar
ppauper
Posts: 11729
Joined: November 15th, 2001, 1:29 pm

Re: Fed rate increase

December 27th, 2016, 8:31 am

inflation is somewhat "too low" from the fed's perspective. The fed says they want inflation to average around 2% per year, and it would seem gradually raising rates will partly make that a self-fulfilling prophecy. As to why 2% is some kind of magic number for inflation (instead of zero), I don't know. 
there is the whole issue of inflation being a tax
the inflation methodology has been changed a number of times over the years
With the pre-1990 methodology, inflation is about 5%
With the pre-1980 methodology, inflation is about 9%
shadowstats inflation
Image
Image

much of the other economic data is being fudged by the feds as well
if you look at accurate GDP data, the US has been in recession since about 2004
shadowstats
Image

actual unemployment is close to 23%, not the "official" 5%
shadowstats
Image

it's also interesting to look at M3 money supply
http://www.shadowstats.com/alternate_da ... ply-charts
Image
the fed stopped reporting M3 in 2006 because it "wasn't useful." By that, they mean it's not useful to them for us to have the information, precisely because the information is useful to us.
look at the growth in M3 from about 8% in 2006 when they stopped reporting it up to about 17% in 2008
 
User avatar
list1
Posts: 827
Joined: July 22nd, 2015, 2:12 pm

Re: Fed rate increase

December 28th, 2016, 5:14 pm

 
User avatar
list1
Posts: 827
Joined: July 22nd, 2015, 2:12 pm

Re: Fed rate increase

December 30th, 2016, 6:52 pm

Subjectively I think the amount of bonds available to sell should be decreased and market should increase its rates. It looks more marketable approach than stating that on a FR meeting.  
 
Josesv
Posts: 13
Joined: November 3rd, 2017, 12:40 am

Re: Fed rate increase

January 26th, 2018, 4:02 am

Excess of USDs makes them ineffective for US economy growth. In classical situation to get money you need to produce and sell productions. In printing money or bonds then buying bonds back they are pumping  economy by money.