The Fed and Interest Rates, Part III

I have written a couple of posts (here and here) on the difficulties the Fed will have in raising interest rates – the mechanical difficulties.  To make a long story short, the substantial excess reserves makes traditional policy tools impotent.  The only meaningful tool available is for the Fed to raise the rate paid on excess reserves.

I am aware that Dr. North has written on this as well, but until I worked through the first post, I didn’t understand why.  Now I have found another author writing substantially the same thing, Cullen Roche of Orcam Financial Group:

…many are still unclear about how the Federal Reserve will raise rates. After all, we're in a new monetary environment in the post-crisis period, thanks to the size of the Fed's balance sheet.

Correct.

To get to the bottom line of Roche’s view:

Importantly, it will announce a change in the "Fed Funds Target Rate", but what it will really be changing is the Interest on Excess Reserves as well as the Reverse Repo Facility. The changes in these rates will help set a target rate for reserves via arbitrage by essentially eliminating the desire to lend at a rate lower than what the Fed is willing to pay.

I have not studied the “Reverse Repo Facility” nor do I care to do so now.  However, the point remains – the Fed will have to increase the rate paid on excess reserves.

Mechanically this is simple.  Politically is another matter – this could be interesting.

The question remains – why the excess reserves?  In other words, to return to an environment of effective traditional policy tools, why doesn’t the Fed sell assets to the banks in exchange for digits that the banks are not using in any case – they are “excess”?

I can think of two reasons: first, the assets – even with the substantial asset price inflation of the last eight years – do not trade at the price the Fed paid; the Fed might not want to deal with the politics of selling assets at a loss to the same banks from which they bought the assets.

Second, a cushion.  With the excess reserves, the next financial calamity will not be as calamitous as the last – with the substantial liquidity available due to the excess reserves, panic selling will not overwhelm markets.

Probably both are in play.