After
a three-year old strategy of selling bonds from their $4.3 trillion portfolio,
the Federal Reserve is now preparing to stroll down a different route shying
away from the unprecedented easing they initiated in battling the recession.
The Feds are now planning to keep their balance sheet close to record levels.
There are some who worry that such sales could cause an abrupt increase in
long-term interest rates, resulting in a relatively more expensive option for
consumers to purchase goods on credit or for companies to invest. Nonetheless,
the Federal Reserve is currently testing new tools that would permit them to
maintain a large balance sheet despite raising short-term interest rates. The
policy could be put into effect as soon as next year and will be used to drain
excess reserves temporarily from the banking system. “It is pretty clear
they are anticipating operating in a situation with a lot of reserves and a
high balance sheet for a long time,” said former Fed governor Laurence Meyer.
The
critique of the system is that it comes with potential risk. In a time of
crisis, for example, investors would naturally move towards safe, short-term
instruments created by the Federal Reserve. This could possibly result in a
lack of funding for the rest of the financial system. According to Bloomberg, the Federal Reserve will meet
in mid-June. We can certainly anticipate that raising the benchmark Federal
funds rate will be on the agenda. This would be the first time since 2006 that
the Feds will raise their Federal funds. Through recent years, the Fed are
known for maintaining a minimal interference in the economy. Under previous
chairman Alan Greenspan, the Federal Reserve was mostly involved with the cost
of overnight loans among banks and the Fed fund rates. For the most part, all
other interest rates were left to the market. In fact, officials were also very
dismissive of any requests coming in asking for subsidies. The reason being is
that subsidizing any one industry would initiate a chain reaction involving
other sectors asking for subsidies as well. After the demise of the financial
firm Lehman Brothers, the Fed changed their policies. In 2008, the central bank
cut the Fed funds rate to almost zero, causing the Fed to seek more ways to
obtain growth. This resulted in an increasing effort by the Fed to influence
longer-term rates on home loans and other debt while pushing purchases of
longer-term U.S. Treasuries, housing-agency debt and mortgage-backed
securities.
On
the other hand, this could potentially be a long-term strategy for the Fed. The
reason being is that the implementation of this strategy would provide safe
assets that are required by the banks in order to fulfill stricter requirements
for capital and liquidity imposed by regulators since 2006. Moreover, a large
balance sheet can also provide continuing options for impacting long-term
interest rates.
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