Fed to Try New Policy Tools Next Year

No sooner will the Federal Reserve raise U.S. interest rates than it must make more decisions on how to drain markets awash in cash and, further down the road, how to shrink its swollen balance sheet.

The U.S. central bank is widely expected on Wednesday to hike its key federal funds rate by a modest 0.25 percent. It would be the first tightening in more than nine years and a big step on the tricky path of returning monetary policy to a more normal footing after aggressive bond-buying and near-zero borrowing costs.

The New York Fed, which handles the mechanics of monetary policy three blocks from Wall Street, will turn on Thursday to a suite of lightly tested tools to pry rates higher.

It will be far more difficult than in the past.

Years of unprecedented stimulus has left the Fed swollen with $4.5 trillion in bonds, and the banks bursting with $2.6 trillion in reserves. All this liquidity has eclipsed the effectiveness of the fed funds market as the central bank’s primary policy lever.

So the Fed will seek to raise rates to the new range of 0.25 to 0.5 percent by setting a floor and a ceiling with other levers that may need to be adjusted on the fly, depending on the reaction of markets.

Questions remain on how aggressively the Fed will rely on these tools and, later, when and how much it will shrink its portfolio.

via Reuters

Alfonso Esparza

Alfonso Esparza

Senior Currency Analyst at Market Pulse
Alfonso Esparza specializes in macro forex strategies for North American and major currency pairs. Upon joining OANDA in 2007, Alfonso Esparza established the MarketPulseFX blog and he has since written extensively about central banks and global economic and political trends. Alfonso has also worked as a professional currency trader focused on North America and emerging markets. He holds a finance degree from the Monterrey Institute of Technology and Higher Education (ITESM) and an MBA with a specialization on financial engineering and marketing from the University of Toronto.
Alfonso Esparza