this pressed For our confusing: The Fed Should Clean Up Excess Reserve Rather Than Raise Rates | Foreign Affairs

For the Fed, Mop Not HikeCleaning Up Excess Reserves Rather Than Raising RatesBy Richard C. KooBy the most recent forecast, the U.S. Federal Reserve is set to raise interet rates on December 16. That it’s happening in the midst of a global economic slowdown is bad news for markets and economies around the world. Even China’s yuan, which had remained stable alongside the strengthening U.S. dollar until recently, had to decouple from it in August to bolster the country’s faltering export industries; it was another decision that shook markets worldwide.Federal Reserve Chair Janet Yellen has been warning of the coming interest rate hike for some time now. She wanted to sound the alarm sooner rather than later because the Fed has injected some $2.5 trillion in excess reserves—17.6 times more than the statutory reserves needed to support the present level of U.S. money supply and lending activity. When a central bank has created such an unprecedented degree of liquidity, particularly with the U.S. economy doing relatively well, inflation could accelerate much sooner than in the past once the private sector is ready to borrow money again. That could force the Fed into an abrupt tightening, which could be very damaging to the market and the economy. The Fed must also avoid creating the impression of being behind the curve on inflation lest it trigger a bond market crash that could send long-term interest rates rocketing.Kevin Lamarque / ReutersU.S. Federal Reserve Chair Janet Yellen testifies before the Senate Banking Committee on Capitol Hill in Washington, July 15, 2014.In spite of the United States’ relatively strong economy, inflation remained subdued because the private sector still maintained a financial surplus of over six percent of GDP, at least through the year ending in the third quarter of 2015, according to the flow of funds data. This is worrying because it means that the private sector continued to save in spite of zero interest rates, a disturbing trend that began when Lehman Brothers collapsed in 2008. It also indicates that businesses and households are still recovering their balance sheets, which may have been hurt when the housing bubble burst in 2008. Their refusal to borrow means that the liquidity injected by the Fed remained with the financial institutions that received them and has not entered the real economy.The fact that the private sector as a whole is still saving money at zero interest rates is worrying because both Japan in 2000 and Europe in 2011 tried to raise rates under similar conditions but were ultimately forced to take them back to zero. In both cases, the economies turned out to be much weaker than some macro indicators had suggested.The Fed’s need to appear vigilant against inflation while facing a still weak global economy suggests that it should reverse the order of monetary policy normalization set forth in September 2014. At that time, it was decided to raise interest rates first before draining excess reserves because the market is more familiar with rate hikes, while a reserve-draining operation would be the first in history and might create unpredictable disruptions.Since the Fed’s September announcement, however, the dollar has skyrocketed and oil prices have collapsed. This means that inflation is likely to stay subdued, undermining the rationale behind rate hikes.Toru Hanai / ReutersA man is reflected on an electronic board displaying exchange rates, August 11, 2010.Meanwhile, reserve-draining operations generally require the Fed to sell bonds. Although that would tend to push bond prices lower and yields higher, the Bank of Japan’s decision in October 2014 to expand its liquidity injections and the European Central Bank’s decision to do so earlier this year have pushed interest rates in many countries to zero or subzero levels. That move boosted Japanese and European investors’ demand for higher-yielding dollar bonds.This means the Fed has the perfect opportunity right now to sell bonds to drain excess reserves—there is robust overseas demand for U.S. bonds, plenty of domestic savings (at least according to the flow of funds data) to absorb the bonds unloaded by the Fed, and a strong dollar and cheap oil keeping inflation concerns in check. These factors all suggest that any pressures that drive down bond prices and drive up bond yields from a reserve mop-up operation are likely to be modest.In other words, the Fed should drain excess reserves first before raising interest rates. If bond yields do climb excessively because the Fed unloads the bonds, the Fed could always calm the markets by announcing an extension of the zero interest rate policy. When the market realizes that the Fed has this fallback option to keep short-term rates low, long-term interest rates (that is, bond yields) are not likely to go that much higher.Enjoy this free article from Foreign AffairsAll visitors get access to one full-length article each month. Register for free to continue readi

Source: The Fed Should Clean Up Excess Reserve Rather Than Raise Rates | Foreign Affairs

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