The Federal Reserve System has taken unprecedented action since the financial crisis and the ensuing recession to ease credit conditions across the entire money market, from interbank lending to home loans. For the record, I believe that these steps were absolutely necessary to both preserve a functioning financial system and accelerate the recovery from the resultant business contraction. Putting the merits of these actions aside however, I wish to examine how the Federal Reserve will implement a normalization of policy.
The Fed's pre-crisis balance sheet totaled 820 billion, while the banking system in aggregate had a mere 1.5 billion in excess reserves. As of this month, the Fed's balance sheet has grown to 2.8 trillion, and will continue to grow larger as the Fed's new mortgage bond purchase program is implemented. Excess reserves now stand at 1.6 trillion. While the tripling of the Fed's balance was has drawn both praise and ire, the 1000 fold increase in banking reserves has been largely ignored by the financial press. It is crucial to note that the Fed sets the Fed funds rate by augmenting or decreasing the aggregate reserve of the banking system by buying or selling securities on the open market. The 1.5 billion in excess reserves could be easily augmented pre-crisis with the sale of a tiny fraction of the Fed's total balance sheet. It is conceivable that in such a scenario a the Fed funds rate could be raised by selling under 100 million in securities. Today however, with banking reserves at 1.6 trillion, the Fed may very well have to dump hundreds of billions or even a trillion worth of securities onto the market in order to raise its target rate. Executing these trades would take years, not weeks or days. In short, the System could not raise the Fed funds rate today even if it wanted to.
The communication of the Fed to maintain a 'highly accomodative' policy until mid 2015 has been interpreted by most actors as forward guidance for the timing of the first rate hike. However, in order to raise rates in 2015, the Fed would need to have already begun quietly unwinding its balance sheet so that it could execute the trades in 2015 that would actually affect a change in the Fed funds rate. On the contrary, the Fed is still expanding its balance sheet. It will certainly surpass 3 trillion, and may even reach 4 trillion if current asset purchase programs are continued or expanded.
In sum, the Fed probably won't be able to raise the rates in 2015 either. The mid 2015 date is most likely the point when the System will begin to sell off its treasury and mortgage holdings. However, the sheer size of the excess reserves, and the reluctance of the Fed to shock the markets by dumping trillions of debt in one shot, will mean it will be years before the unwinding causes rates to rise. In sum, it is not at all unlikely that the Fed will not be able to swiftly and effectively target the Fed funds rate until 2019.
As the Fed has intervened in unprecedented ways to provide stimulus to the economy, it will also take non traditional methods to withdraw this stimulus at the appropriate time. Powerless to rapidly change the Fed funds rate, the Fed will be forced to attempt to quarantine excess banking reserves by raising the rate of interest it pays on deposits at the System's twelve banks. This may tightened credit conditions, but it is uncharted territory. It must also be mentioned that this policy essentially entails paying the banks to withdraw credit from the public. This could become a political problem for the Fed, considering that Congress only just granted the Fed the power to pay interest on deposits in 2008.
No matter which way you look at it, the Fed's exit strategy will be a long and highly complex process that will take years to execute. With the mind boggling growth of the monetary base, and the impracticability of selling trillions of dollars worth of securities all at once, 2020 is a reasonable estimate for the first increase in the Fed funds rate.
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