Gauge on Interest Rate Hike
Currently, interest rate hike is usually triggered by the rise in inflation. When there is a high inflation, then, interest rate hike will be implemented to cool down the market. However, is this a good indicator for interest rate hike. From the lesson in the Financial Tsunami, we may need to revise the policy on timing of interest rate hike.
Body of Article
Currently, interest rate hike is usually implemented when there is a high inflation which is usually measured by the consumer price index. The common belief is that inflation is an indication of economic overheat. However, from the experience of the Financial Tsunami, this method may not be a good way to guard against an economic overheat or damage to the economy due to low interest rate.
After the IT Bubble, the interest rate was drastically lowered from 6.53% in Jun 2000 to 0.98% in Dec 2003. Though the interest rate rose back to 5.26% in Feb 2007, the damage to the economy due to the asset bubble had already done. This eventually led to the Financial Tsunami in 2008. It seems that the interest rate cut after IT Bubble was too deep and too long and the subsequent interest rate hike back to normal was too slow.
The cut in interest rate may need to be stopped earlier and rise in interest rate may need to be started earlier. The not-fast-enough action could be because of timing the necessity for interest rate hike be too reliant on inflation and unemployment. Instead of just looking at the inflation and unemployment, some more indicators may need to be added to gauge the economic overheat due to asset bubble.
Asset bubble due to low interest rate usually happens in two sectors: property market and stock market. Hence, an indicator to gauge the extent of an asset bubble in these two sectors can help us to lower the risk of belated interest rate increase.
So, a new method of two indicators might be added to the conventional inflation benchmark: Consumer Price Index, to form a new index. It is proposed to call it asset-adjusted CPI.
In addition to measure the inflation with the rise in the consumer price level, the 30 year Treasury Bond interest rate times the property market capitalization and the 10 year Treasury Bond interest rate times the stock market capitalization index be added to the calculation of the asset-adjusted CPI. As the size of the property market and stock market is very big, the weights of these two calculations in the asset-adjusted CPI should be reduced by a weight after careful consideration to avoid distortion of the resulting economic overheat measurement. What are the weights being used could be a topic for further research.
As a result, even if there is no or low inflation, with the measurement of asset-adjusted CPI, the looming asset bubble problem will also be in the perspective of monitoring of the economic overheat.