US Economy

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The market may believe the U.S. Federal Reserve moved too quickly on raising interest rates last year, but the chief economist at the Nomura Research Institute offers a reason why they had to act when they did.

"The fundamental starting point is that the central bank that did the quantitative easing (QE) will have to move faster than the central bank that didn't do QE," Richard Koo, chief economist at Nomura Research Institute, told CNBC.

With no academic or theoretical work around on when was the right time to raise interest rates after QE, Koo said that if the Fed had a choice to raise rates too early or too late, they'd rather be ahead of the curve.

For the first time in almost 10 years, the U.S. Federal Reserve decided to raise its benchmark policy rate last December, to between 0.25 to 0.5 percent.

Federal Reserve chair Janet Yellen (L to R) and former Federal Reserve chairs Ben Bernanke and Paul Volcker appear together for the first time in New York, April 7, 2016. The panel is geared toward millennials and focused on decision-making with international implications.
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While the market had anticipated a rate hike, there have been significant volatile swings since then in financial markets, driven partly by concerns over global economic growth, China and oil prices.

However, Koo said as this is the first time the Fed has tried this tactic, volatility remained "unavoidable" due to uncertainty.

"Volatility I think is unavoidable and I think market will start getting used to it, but it will be nonetheless very volatile for years to come until this is all worked out and normalized," said Koo.

Koo went on to add that while QE was "very easy" to get into, it was very difficult for an economy to come out of and the market has to understand that, saying that QE itself acts like the "unwanted child of balance sheet recession."

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His comments come as Fed Chair Janet Yellen dismissed suggestions that a December rate hike was a "mistake". Speaking in New York on Thursday, Yellen said that the gradual path of rate increases would be appropriate and that they would "very carefully" watch what was happening in the U.S. economy in the future.

The economist added that the Fed was also limited in its choices by its mandate to maintain inflation at or around 2 percent.

"The target's 2 (percent), why are they tapering at 1.1 (percent)? And in December they raised interest rates last year, why are they raising interest rates when inflation is only 1.3 (percent)? Because if they waited until 2 (percent), it's too late."

"They'll be viewed as behind the curve and they may be forced into very abrupt tightening, which could be very, very disastrous for the market as well as for the economy."

"So the market (will) still say that the economy is not all that weak, (saying) 'why are you raising interest rates?' So there is that conflict which we've never seen before in our history as QE was never tried until this time around."

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Koo did offer an alternative path the Fed could have chosen to avoid market volatility: reducing its balance sheet.

"I think now is the ideal time to reduce the Fed balance sheets, because the U.S. dollar is strong, foreign demand for U.S. papers is very strong, (there's) very weak demand for money within the U.S. private sector, no one's borrowing any money in the United States yet, and oil prices are so low."

"So if I was trying to familiarize the market types about what the Fed is going to do with these huge balance sheets, now is the ideal time to make them understand what the Fed is trying to do."

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