The Three Phases of Fed Tightening

by Jeremy Siegel

The Fed’s action to flood the financial system with liquidity in the wake of the Lehman bankruptcy has prevented another Great Depression. But the Fed’s job is far from over. As the economy recovers, Ben Bernanke must raise interest rates and withdraw the over $1 trillion of liquidity -- now located in the excess reserves of the banking system -- that he has created to shore up the financial system or risk a flare-up of inflation. This will become necessary because as the economy improves, the threat of inflation rises. Fortunately, the Fed now has a new tool to ease the economy and the financial system into a higher-interest-rate environment.

3 Steps to Normalization

The Fed has already taken its first steps to normalize policy. In February the Fed raised the discount rate 25 bps to 75 bps, putting it now 50 bps over the upper level of the 0 percent to 0.25 percent range the Fed has set for the Funds rate. Normally the discount rate is 100 bps above the funds target, but during the financial crisis the Fed wanted to make sure that banks had access to adequate reserves at cheap rates, and lowered the discount rate to 50 bps while increasing accessibility and the maturity of Fed lending.

With the proliferation of other Fed funding facilities, the Fed Funds market became less liquid and the volume of transactions decreased. To bring liquidity back to the funds market, the Fed must continue to raise the discount rate to 1.25 percent, restoring its normal relationship to the Fund target.

Phase II Tightening

The second stage of the normalization will be to raise the Fed funds target and simultaneously raise the interest the Fed pays on reserves.

The thought that the Fed might soon have to raise its policy rate sends chills down the spines of historians who have studied central banking. The mid 1930s were another period, just like today, when the banks held a massive quantity of excess reserves and interest rates were near zero. In order to prevent those reserves from fueling inflation, the Fed sharply raised reserve requirements on banks in July 1936 and again in January of 1937.

But, much to the Fed’s surprise, the banks wanted to keep those excess reserves and responded to the higher reserve requirements by calling in large quantities of loans to restore their reserve position. The decline in deposits and lending brought about a sharp recession and industrial production fell more than 30 percent.

In contrast to 1937, the Fed now has an additional monetary tool that greatly reduces the risk that mopping up excess reserves too early will cause a similar contraction. In October 2008, Congress granted the Fed power to pay interest on both required and excess reserves for the first time.

This new policy is a game changer. Before, the Fed could only raise interest rates by making reserves scarce relative to their demand. This was done by “open market sales,” or selling government bonds and debiting the reserve accounts of banks.
But now the Fed can maintain a large quantity of reserves to satisfy the banks’ desire for liquidity and still fight inflation by raising the interest rate that its pays on reserves in conjunction with the Fed Fund target. This will increase the demand for reserves and reduce the amount of reserves that need to be drained to achieve a given interest rate target.

Phase III of Tightening

But the Fed cannot forever use the interest rate on reserves as its only tool to raise rates. As the economy recovers, banks will want to lend out an increasing fraction of their reserves in the higher-yielding loan market. To prevent excess lending, the Fed must then mop up those excess reserves through traditional open market sales and raise the Fed Funds target well above the rate it pays on reserves. As the funds rate is raised above the rate paid on reserves, the quantity of reserves will decline and the Fed’s balance sheet will then shrink.

Time for Tightening Near

Although inflationary pressures appear quiescent now, the Fed should not delay raising interest rates for long. Several central banks have already been moving into a tightening mode. The Fed’s new tool gives them the opportunity to shrink their balance sheet gradually and allow banks to maintain excess reserves without suffering an undue rise in cost of doing so. When the recovery is well on its wayl, the Fed can then shrink its balance sheet by raising the funds target above the rate paid on reserves.

To be sure, raising rates will at first be painful for the capital market, but in the long run a Fed tightening is good for both the bond and stock markets. It is a signal that the Fed sees the recovery as sustainable and is serious about controlling inflation and maintaining the purchasing power of the dollar. This action will be especially welcome by foreign investors who have funded a large part of our recent deficits. The Fed must not squander its credibility as an inflation fighter and can now do so without unduly squeezing the financial system.