federal reserve

The Wall Street Journal
By Justin Lahart
JUly 13, 2014

Any time the Federal Reserve raises interest rates, there is risk to the economy. The next time it does so will be far more fraught than ever before.

The Federal Reserve is hoping it will be able to raise rates without rattling markets. Doing so after injecting so much money into the banking system may not come easily.

With its bond-buying program winding down and the job market on the mend, sometime next year the Fed will likely raise its target on the federal-funds rate from the zero-to-0.25% range it has kept it in since late 2008. Figuring out when to tighten policy is always a difficult exercise: Do it too hastily, and the economy is less buoyant than it could have been; linger too long, and dangerous excesses can build.

What makes the current situation especially tricky is that the Fed’s old way of raising rates won’t work anymore. In the past, the Fed would raise rates by selling bonds through its open-market operations, thereby withdrawing reserves from the banking system. This made it harder for many banks to meet the reserves they are required to hold at the Fed. In turn, this would drive up demand, and costs, for borrowing funds overnight from other banks. That would drive the federal-funds rate higher.

But as a result of the huge Treasury and mortgage-buying programs the Fed kicked off during the financial crisis, bank reserves in excess of what they are required to hold have swollen by more than $2.5 trillion. With so much liquidity in the system, setting a target for the federal-funds rate, and then using open-market operations to adjust reserves until that goal is hit, isn’t tenable.

This situation led to speculation that the Fed might target a different short-term rate. One possibility was the interest the Fed pays on reserves banks keep at the Fed, now set at 0.25%. Another potential option is to use the reverse-repurchase facility the Fed has been testing since last year, through which it lends bonds in exchange for cash. One proposal called for the Fed to use such so-called reverse repos as its main rate-setting tool, and set the interest rate on reserves at the same levels.

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