Is the Fed stuck up in a tree with no way down?

In a much-awaited move, on Dec. 16, the Federal Reserve ended an unprecedented seven-year experiment with keeping its target short-term interest rate between zero and 0.25 percent. Despite all the hullaballoo, this move was the non-event of 2015.

Now, the Fed faces at least two big challenges in unwinding its balance sheet. First, as it began large-scale purchases of assets, and also paying interest on reserves, those reserves skyrocketed to more than $2.5 trillion (from pre-crisis levels of around $10 billion—see chart). This jump by a factor of 250 was a simple response to the fact that banks could earn, risk-free, more from the Fed than by lending to other banks or from other safe assets.

With competing rates near zero, the Fed could get away with a premium rate on reserves, but as rates begin inching up, continuing that policy becomes untenable. If nothing else, it would mean billions of dollars monthly in payments to banks. Even some Fed officials are concerned that, like a cat that managed to climb up a tree, the way up was possibly much easier than the trip down. Once the interest-rate premium disappears, banks could quickly seek to unload literally trillions of dollars of reserves, to which the Fed would likely have to respond by corresponding sales of assets.

Which brings us to the second challenge: The Fed has supported the mortgage-backed securities market by buying more than $1.7 trillion in mortgage-backed securities (see chart), accounting for about half of the increase in the Fed's assets. The remainder is mostly longer-termTreasury securities, purchases of which have helped to prop up that market and accommodate the federal government's massive borrowing. The Fed is undoubtedly reluctant to engage in large sales of either of these classes of securities for fear of undermining their value.

The Fed did nothing to address either challenge. The committee raised the interest rate on reserves to 0.5 percent, keeping it above its target for the federal-funds rate, and will maintain its holdings of Treasury and mortgage-backed securities — making it a neutralized increase of an inconsequential interest rate. How the cat is to be rescued from that tree remains a mystery.

Unnoticed behind all the theater is that the Fed's efforts over seven years have borne little fruit. The recovery from the deepest recession since the 1930s has been the most feeble. This is not the Fed's fault; it merely highlights the futility of using monetary policy against forces it was never designed to counter: Slow productivity growth the past ten years; changing demographics (notably the aging of the baby boom into retirement); fiscal red ink from entitlements and higher interest payments; the China slowdown; and turmoil in the European Union. The Fed has labored under the illusion that it would have some tangible impact, but it seems mainly to have boosted asset prices without accelerating economic activity.


The Fed has provided only limited information on how or when serious policy normalization will occur. Recent statements indicate that the interest rate on reserves will remain above the fed-funds target range, and asset drawdown will be limited to attrition from not reinvesting income. For now, the committee has breathing room: With 3-month rates remaining below 0.25 percent, a strong dollar, and low energy prices, there is little pressure for additional moves. But as conditions change, the aforementioned plans are not sustainable.

The Fed should begin unwinding now, not wait until conditions force them. The rate on reserves could be lowered to 0.25 percent, accompanied by modest asset sales, without triggering a large response. If managed well, this "quantitative tightening" will be benign — the mirror image to quantitative easing's modest impact—but will reduce uncertainty. And it will put the onus for economic revival where it belongs, on fiscal and regulatory policies.


Commentary by James A. Kahn, former vice president of research at the Federal Reserve Bank of New York. He is now the Henry and Bertha Kressel University Professor of Economics and chair of the Economics Department at Yeshiva University in New York. Follow him on Twitter@jamesakahn.

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