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Fed To Raise Rates Next Year? Don't Worry!

There has been much breathless analysis and commentary on exactly when the Fed will start raising rates, the precise end-point (4% versus 3.75% etc), and too little attention paid to how they will raise rates. I hypothesize that in the post-QE era, "raising rates" may not have the same effects as it did in the pre- Bernanke era.

Let us quickly revisit how the Fed used to tighten policy in the pre-Bernanke era. Bank reserves used to be an important constraint to bank lending and banks generally attempted to maintain reserves as close to required reserves as possible. When the economy overheated, the Fed would reign in exuberant bank lending by raising the target Fed Funds rate. The Fed would then extract reserves from the banking system until the FF rate rose up to the Fed's desired target. Since the banks were reserve constrained, all this would dampen bank lending and slow down the economy.

How about now? With approximately $3 Trillion in excess reserves in the banking system, courtesy of QE, the Fed intends to take a different approach. The Fed can no longer withdraw sufficient reserves from the banking system to engender an increase in short term rates and constrain lending. Instead, the Fed intends to simply pay the banks a higher interest on reserves. Perhaps this will be accompanied by other techniques such as reverse-repos to enable non-banks , such as money market funds to also earn this new higher rate. This would have the effect of raising short term rates across the board. Current expectations are that the Fed will embark on this process sometime in 2015, with very gradual increases to something like 2% by the end of 2016.

It is interesting to speculate on how this new approach may have effects quite different to previous Fed tightening cycles in the pre-Bernanke era. Now, banks are not reserve constrained; ie. banks don't worry about their reserves in deciding whether to lend more aggressively or not. On the other hand banks are highly sensitive to capital ratios - driven by their levels of capital and the riskiness of their assets. It is not at all clear that when the Fed starts paying banks a higher interest on reserves, it will act to dampen the banks' enthusiasm to lend. To the extent that bank profits are enhanced by the increase in interest earnings on what are now very high reserve balances ( approximating $3 Trillion) partially offset by whatever increased interest they pay on deposits, banks may in fact be more willing to lend. This may be the key thing to watch. Will interest on deposits increase in lock step with the increased interest on reserves? If not, banks may enjoy a period of significantly enhanced profitability and be more eager to take risk and lend .

The Fed is apparently more concerned about the tepid economic growth than inflation at this time. They seem to be willing to err on the side of tolerating higher inflation rather than prematurely snuffing out the tenuous economic recovery. So, by the time they get around to actually paying banks a higher interest on reserves, its quite possible that inflation will be increasing smartly and the bond market will be demanding the Fed do something about it. It will be in this environment that the Fed's new experiment in policy tightening will play out. And, it may not actually work. Banks' willingness to lend may actually increase and demand for loans may also increase as investors clamor to borrow to acquire assets to protect themselves against the rapid inflation.

If the new policy tightening approach fails to constrain exuberant bank lending and inflation it is likely the Dollar will decline and further exacerbate inflation. All this may take some time to play out, and we may be well into 2016-2017 by then. Then what ? Well, one possible technique to try out may be for the Fed to raise reserve requirements such that the actual reserves in the banking system become "required reserves". Then the Fed could actually go back to the old fashioned approach to policy tightening. But that is just wild speculation on my part.

In summary, it is far from obvious that the new policy tightening approach of paying banks a higher interest on reserves will play out like previous Fed tightening cycles. The risks seem to lie in the direction of overheated markets, excessive speculation and inflation. Since most people have been heavily conditioned by the deflation scare form 2008, there is a natural tendency to believe that inflation and overheating will be a relatively easy problem to solve. It may not be.