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Data dilemma: To raise or not to raise the interest rate

By Roberto Rigobon, Society of Sloan Fellows Professor of Management and Professor of Applied Economics at MIT Sloan; a research associate of the National Bureau of Economic Research; and a visiting professor at IESA.

Roberto Rigobon

Nearly seven years ago the Federal Reserve put its benchmark interest rate close to zero as a way to bolster the economy and has not raised that rate since. For the past several months, the Fed has struggled to decide when it will dictate an increase, and it appears the announcement is imminent this week. While this increase is actually more of a "normalization," a December tightening of rates will have lasting consequences. 

First, let's address why leaving interest rates too low for too long is a bad idea: primarily because low interest rates can lead to bad behavior. Banks might take too much risk--after all, almost every investment looks good when the financing cost is close to zero. Individuals are also more likely to borrow too much and save too little--hence increasing leverage ratios. What harm is a loan when the interest rate is negligible?

By moving interest rate targets up or down, the Fed attempts to achieve maximum employment, stable prices and stable economic growth. The Fed will tighten interest rates (or increase rates) to stave off inflation. Conversely, the Fed will ease (or decrease rates) to spur economic growth. Raising the rates is good for the economy, but only after the economy has consolidated and is in good health. Which, right now, it is.

So if the economy is strong, why is it taking so long for the Fed to decide? To put it bluntly, they have bad data.

Currently, the Fed relies mostly on the Phillips Curve, an important but decades-old concept that shows the correlation between inflation and unemployment. Inflation is particularly prone to rise when the unemployment rate falls below the "natural rate." By moving interest rate targets up or down, the Fed attempts to keep the economy in balance and achieve maximum employment, stable prices, and stable economic growth--tightening (raising) interest rates to stave off inflation or easing them to spur economic growth. However, the historical relationship between unemployment and inflation is problematic and hasn't worked very well in the last few decades in the US. 

The Billion Prices Project

My job, and that of my colleagues, is to find new ways to construct macroeconomic data. About eight years ago, another professor at MIT, Alberto Cavallo, and I started computing daily inflation rates for several countries around the world. In what we call "The Billion Prices Project" (BPP), we collect data from online stores (and other online sources that post prices) and compute alternative inflation indexes. The online and offline inflation rates are not identical, but they tend to converge over a period of six to nine months. We have been tracking these rates with incredible accuracy since we began the project, and from this data we can see the relationship between prices and the cost of oil, the strength of the Euro, and many other factors. The high-frequency price data from the Internet is then aggregated to measure inflation on a daily basis, helping government officials, economists, and investors learn macroeconomic trends in real time.

Since its inception, the BPP U.S. inflation index has moved with reasonable proximity to the U.S. Consumer Price Index (CPI), an inflation index published by the Bureau of Labor Statistics that tracks monthly data on the prices paid by urban consumers for a representative basket of goods. The CPI's annual percentage change is used as one of the canonical measures of inflation and is often used by the Fed in its inflation forecasting. However, it is published monthly at a lag and doesn't give policymakers and economists the same timeliness that the BPP can provide. 

What the data tells us

Since March, policy makers have reiterated that the Fed will seek to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term. However, the data from our Billion Prices Project tells us that we’re already there, and have in fact been there for months.

Our recent data from the BPP on the year's inflation for the US is -101 basis points. When you correct for the negative effect from oil price declines, this increases to 107 basis points, and when we eliminate the negative impact of the appreciation of the US dollar, it increases to 187 basis points. This last number is extremely close to 2 percent (1 percent = 100 basis points). This is consistent with our point that the underlying data highlights a situation that is much better than the one inferred from the official numbers.

If the Fed had looked at the data at its source, they would have increased rates at their last meeting in October.

No so happy holidays

So while the economy is ready to sustain an increase, a decision by the Fed to raise rates in December (a decision that would be made next week) is a bad idea. In fact, it would be a horrible decision, from the point of view of implementation. December is an illiquid month, and the worst time for the possibility for the stock market to overreact. Treasury-market liquidity tends to shrink in the final days of the year as traders, like everyone else, go on holiday and close their positions; and many firms want to buy and hold on to government bonds to make their books more attractive at year-end review. While the markets have had more than enough time to prepare, a rate hike announcement could lead to particularly heightened market volatility.

The Fed missed a golden opportunity in October, so we'll brace ourselves for the likely December hike.

Roberto Rigobon teaches in the Advanced Management Program, Strategies for Sustainable Business, and Understanding Global Markets: Macroeconomics for Executives at MIT Sloan Executive Education.

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