The Fed: Making Use of All Policy Tools by Richard May

When the Fed decides to remove accommodation from its policy, which it already has hinted at doing with its recent tapering, it will need to start thinking about reducing the size of its balance sheet as well as preventing inflation and future bubbles in both the asset and housing markets. Once tapering has progressed to the point where the Fed is no longer making monthly purchases of long-term bonds, therefore, it should consider starting to sell some of its securities, a fitting conclusion to the quantitative easing program that the Fed has put in place.

The Fed Funds interest rate is a separate tool from the QE, whose purpose is to affect short-term interest rates, not long-term ones. Therefore, changes regarding the Fed Funds rate should not be tied to changes in QE. However, if the economy seems to be returning to pre-recession levels, the Fed should not hesitate to raise the Fed Funds rate, as that is the primary tool that it uses. As to the magnitude by which the rate will be raised, that should depend partially on the Fed’s forecast on the economy and the different paths that the economy would take based on differing interest rates, and partially on future predictions of different economic indicators to adhere to the Taylor Rule.

In terms of other interest rates, the Fed should keep an eye on the discount rate and the interest paid on excess reserves, but as the economy recovers, these tools should be secondary to the Fed Funds rate. Because these interest rates affect specific aspects of the financial market, only when these factors change drastically should the Fed touch them. For example, if bank lending, as it has been doing, stagnates to the point where trillions of dollars of excess reserves are being held at the Fed, then the interest paid on those reserves should fall (ignoring the zero-bound) until bank lending reaches an acceptable level. Also, if the economy proves slow to recover, but the Fed still needs to shrink its balance sheet, lowering the interest on excess reserves to increase lending while at the same time selling securities provides a way to enact expansionary policy while also reducing the size of the Fed’s balance sheet.

Also, because the Fed has a responsibility to ensure the stability and survival of the financial market, it should take a more active role in bank regulation. The Fed is the institution that knows its own goals, and whether or not they are being achieved, better than any other organization. Because the actions of banks significantly impact the financial market as a whole, and the Fed knows better than anyone else where the financial market needs to be, it follows that the Fed would know what the banks ought to do to keep the financial market stable and growing. Therefore, the responsibility to institute regulation to incentivize banks to do what’s best for the market should lie with the Fed.