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The Fed's Dilemma

By Jack Kelley

After the world markets went through a rough and volatile summer, investors are searching for stability in the Federal Reserve Board's upcoming September meeting. If the Fed decides to raise its interest rate target, it will signal that it feels the U.S. economy is growing at a reasonable rate, with unemployment falling and inflation potentially rising.

Beyond the question of when the Fed will raise rates, the more serious topic exactly how the Fed will raise rates, and the costs of doing so given its enormous balance sheet.

Before the 2008 financial crisis, if the Fed wanted to lower the short-term interest rate in the economy, it would lend to commercial banks to add funds to the banking system. The idea was that more money would entice the banks to lend more to companies and people, for a lower fee—or interest rate—and when this new money was put towards robust projects, the economy would grow. Likewise, if the Fed wanted to raise rates, it would do the opposite: be a borrower and withdraw funds from commercial banks.

After the 2008 crisis, the Fed expanded its balance sheet by buying bonds, specifically Treasuries, at an enormous rate. A New York Times article summed it up pretty nicely when it said that, if the money banks carried before 2008 were a single brick, now we have 256 additional bricks.

Naturally, with a 256 times increase in the banking system’s reserves at the Fed, using the old form of monetary policy will probably not be effective unless a large quantity of money is removed from the system. That would be risky for the economy and the financial system as a whole.

Instead, when the Fed decides to raise rates, it will most likely raise the interest rate that it pays on reserves, the deposit rate, paying commercial banks to keep their money with the Fed and not lend it out. Banks can get more than the current 0.25 percent that the Fed offers from consumers and companies, but only with additional risk. The Fed’s rate is virtually risk free, which is part of the reason that banks have been tying up their reserves and not lending as much in the past few years.

When the Fed decides to raise this rate, holding reserves with the Fed will only get more attractive, especially with a global outlook that has been weakening with emerging markets getting hammered by low commodity prices, Europe’s limping economy, and China’s slow down.

It is vital that the Fed time its deposit rate hike and each subsequent hike harmoniously with demand growth, or the actual market rate in the economy, before banks are keen on lending their reserves to the economy.

However, paying interest on reserves is not a cheap task for the Fed, especially if this interest rate were to rise. In 2013 and 2014 alone, the Fed has paid banks not to lend, at its minuscule rate of 0.25 percent. Just for the sake of argument, let’s say the economy is operating with higher demand for loans and banks want to lend out their reserves. The Fed can either raise its deposit rate and pay banks even more not to lend the money it already paid them, or can let them respond to market forces, lending this money out and creating an abundance of new money, risking a rise in inflation. Whether this inflation is dangerous depends on how effective the Fed is in the years beforehand.

The Fed has another option, too.

It can start to sell some of the assets it holds on its balance sheet, like U.S. Treasuries, or the mortgage backed securities it bought back in 2008. The obstacle is that with so many assets ($2.5 trillion of Treasuries and $1.7 trillion of mortgage backed securities), it would have to sell a lot to have significance, and selling this large of a volume would drive the prices of these assets down, potentially hurting banks that held similar assets.

What’s more, the Fed isn’t the only central bank retaining these assets. The Fed holds about $2.5 trillion, and China and Japan combine to hold another $2.5 trillion.

Speaking of which, China recently tried to stabilize its currency rate, after the yuan devalued severely in the weeks before. The Chinese swapped Treasuries for dollars then sold dollars to buy yuan, both hurting the value of the dollar and Treasuries.

This temporary pullback of the dollar is not a problem; the dollar has strengthened substantially against a basket of currencies since July of 2014. The problem lies in the risk of U.S. Treasuries losing their market value.

If China, or any other country, begins to service its currency through sale of commonly held American debt, U.S., bond values will fall.

This poses extreme risk to the Fed because its assets are primarily U.S. Treasuries as well, meaning it will lose value on its assets but remain in debt on its liabilities if we see foreign nations take Treasury dumping to a larger scale. Furthermore, it will probably think twice before devaluing these assets even more by selling them to reduce its balance sheet. At the end of the day, though, the Fed will have to make a decision to keep the economy on keel.

It goes without saying that the Fed’s job is not easy. But in the post-2008 era, with an inflated balance sheet, slowing global growth, and central banks that are now intervening with their currencies, the Fed’s task will take some intelligent thinking to navigate.

Jack Kelley ’18 is an economics concentrator living in Pforzheimer house.

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