Guest column: Federal Reserve is walking a tightrope

The U.S. economic recovery began accelerating this past year, its sixth year of recovery.

Recently, the Federal Reserve stated it planned to slowly raise interest rates in the second half of 2015 or sometime in 2016. The Fed walks a tightrope as it considers altering monetary policy.

The Fed currently holds $4.5 trillion in assets, including $2.5 trillion in treasuries and $1.7 trillion in mortgage-backed securities. Before implementing the program of quantitative easing, the Fed held just under $1 trillion in assets.

Also, the banking system now holds $2.6 trillion in excess reserves, a 1,300 percent increase from the $2 billion it held before the Great Recession. This huge overhang in excess reserves constitutes the fuel that could ignite excessive inflation.

The Fed’s decision to pay interest on bank reserves in October 2008 of 0.25 percent, the fall in the federal funds rate to less than 0.25 percent and the Great Recession largely precipitate the accumulation of these enormous reserves and liquidity in the banking system.

How does the Fed plan to unwind its balance sheet and absorb the overhang of excess reserves?

Under ordinary conditions, the Fed withdraws excess liquidity by selling government securities in the open market, leading to lower asset prices and higher interest rates. Rather than withdrawing this excess liquidity, however, the Fed now plans to keep the excess liquidity in the short run and the size of its current balance sheet by increasing the interest rate on bank reserves and locking up the excess reserves. Then, in the long run, it will withdraw the excess liquidity at a more measured, less frenetic pace.

Although this strategy apparently differs from the conventional approach, the same dangers exist. Raising the interest rate on bank reserves too little can release more reserves than desired, financing too much money and credit creation, overheating the economy and igniting inflation. Raising the interest rate on bank reserves too much keeps more reserves locked up than desired, financing too little money and credit creation and possibly leading back into recession.

Using the interest rate on bank reserves to lock up excess liquidity in the short run and withdrawing the excess liquidity in a sustained and systematic manner in the long run provides the best policy choice.

The Fed, however, embarks on an untested policy path. Let’s hope economic shocks — most likely European and/or Chinese events — don’t topple the agency off its high-wire act.

Tags: The Sunday
Business

Stephen M. Miller is a professor of economics at the Lee Business School at UNLV and chairman of board of directors of the Economic Club of Las Vegas.

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