FOR FED, RAISING RATES WON´T BE EASY / THE WALL STREET JOURNAL

Heard on the Street

For Fed, Raising Rates Won't Be Easy

Central Bank's Old Method Won't Work Anymore

By Justin Lahart

July 13, 2014 2:38 p.m. ET

Any time the Federal Reserve raises interest rates, there is risk to the economy. The next time it does so will be far more fraught than ever before.

The Federal Reserve is hoping it will be able to raise rates without rattling markets. Doing so after injecting so much money into the banking system may not come easily.

With its bond-buying program winding down and the job market on the mend, sometime next year the Fed will likely raise its target on the federal-funds rate from the zero-to-0.25% range it has kept it in since late 2008. Figuring out when to tighten policy is always a difficult exercise: Do it too hastily, and the economy is less buoyant than it could have been; linger too long, and dangerous excesses can build.

What makes the current situation especially tricky is that the Fed's old way of raising rates won't work anymore. In the past, the Fed would raise rates by selling bonds through its open-market operations, thereby withdrawing reserves from the banking system. This made it harder for many banks to meet the reserves they are required to hold at the Fed. In turn, this would drive up demand, and costs, for borrowing funds overnight from other banks. That would drive the federal-funds rate higher.

But as a result of the huge Treasury and mortgage-buying programs the Fed kicked off during the financial crisis, bank reserves in excess of what they are required to hold have swollen by more than $2.5 trillion. With so much liquidity in the system, setting a target for the federal-funds rate, and then using open-market operations to adjust reserves until that goal is hit, isn't tenable.

This situation led to speculation that the Fed might target a different short-term rate. One possibility was the interest the Fed pays on reserves banks keep at the Fed, now set at 0.25%. Another potential option is to use the reverse-repurchase facility the Fed has been testing since last year, through which it lends bonds in exchange for cash. One proposal called for the Fed to use such so-called reverse repos as its main rate-setting tool, and set the interest rate on reserves at the same levels.

But minutes from the Fed's June meeting, released July 9, show that for now, policy makers are unwilling to take this tack, and that they believe "the federal funds rate should continue to play a role." One reason is the Fed probably doesn't want to further complicate the process of increasing borrowing costs by changing the short-term rate it focuses on. Another is that the federal-funds rate is deeply embedded in financial markets, with trillions of dollars in instruments tied to it.

While the Fed will maintain a focus on the federal-funds rate, the minutes also showed many policy makers want it to continue targeting a rate range during the tightening process, rather than going back to the pre-crisis practice of targeting a specific rate. This acknowledges the difficulty of targeting a specific federal-funds rate when reserves are so high.

This is a second place where reverse repos and the interest the Fed pays on reserves might come in. A number of money-market funds and others have signed up for the reverse-repo facility, but only banks can earn interest on reserves. The reverse-repo facility sets a floor on overnight rates. If a money fund can earn more through the facility than by putting money into a bank, it will go with the facility. Banks place overnight money that money funds have deposited with them into reserves, so interest rates on reserves become the ceiling. The banks use the federal-funds market to facilitate this process, so the federal-funds rate falls into the range.

That, at least, is how things should work in theory. How it works in practice is something the Fed will only get a real feel for once it begins increasing rates. 

Those increases, when they come, may be pretty incremental to start with. That isn't just because the Fed wants to make sure it doesn't damage the economy, but because it will be trying to do something it has never done before.