Tuesday, October 13, 2009

Too early for rate increase

Recent decline of US dollar reflects investors' expectation that it may take long time for the Fed to raise interest rate, probably slower than ECB, certainly slower than commodities exporting countries.

Interest rate differential is the most important factor in predicting currency movement.

The first graph below shows you the 4-week average of jobless claims ---we are clearly out of recession. Yet we are nowhere near the normal. The unemployment rate will certainly pass 10%, and it will take a while for the rate to peak.

(click to enlarge; graph courtesy of calculatedrisk)

The second graph shows you that it usually takes the Fed more than a year after the peak of unemployment rate to raise interest rate, which means the Fed won't raise interest rate until 2011, at least. It looks like investor's concerns are well justified.

(click to enlarge; graph courtesy of calculatedrisk)

But we know Bernanke is no Greenspan. Giving the huge liquidity the Fed has put into the system, the Fed may need to raise interest rate much quicker and more aggressively than what is suggested by recent history.

I am still not sure how the Fed can get the timing right. There is a huge risk down the road that the Fed raises interest rate too soon so killing the nascent recovery; however, if the Fed raises rate too slow and by too little, it may cause sharp jump of inflation (expectations).