The Perversity Of 2004-2005 Federal Reserve Policy

Abstract

The current policy stance of the Federal Reserve System – to signal that it will continue to raise interest rates at a “measured” pace – creates perverse incentives for agents with rational expectations.  The knowledge that interest rates will rise in the future at a known rate implies that current demand for real assets purchased on credit will be higher relative to what demand would be in the absence of that knowledge.  Policy effects are perverse in the sense that the usual intent of raising interest rates is to slow demand for real assets, not to increase it.  The current “froth” in housing markets observed by Fed Chairman Greenspan may be an unintended outcome of this policy.  A rational expectations theory is presented to back up this argument.