The last puzzle is what the Fed should do to raise interest rates. Back before the financial crisis and QE 1-2-3 the Fed could adjust interest rates by adding or draining bank reserves from the nation’s banking system. That worked than because the bank reserves were near the margin where a small drain would push the Fed funds rate up and a modest addition would send it down. No longer.
Following quantitative easing, the banking system is awash in reserves and there is no way the Fed can drain enough to make a difference. There are other approaches available: adjusting the interest rate the Fed pays to banks on excess reserves held at the Fed is one, auctioning reverse repurchase agreements is another.
These will work, but with little experience the central bank could overshoot the target or miss completely. Like the Fed, the market has little experience with these new operating procedures. When the Fed does raise interest rates, will the market know how to respond or will it over react and send rates either surging or collapsing. The answer to that question may be the topic for the 2015 Kansas City Fed conference.
This article was written by David Blitzer, chairman of the index committee, S&P Dow Jones Indices.
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