FED and their control of interst rates

[anders]

Hi guys, Im trying to get me head around this topic and would very much appreciate your help, as I understand it - in short - FED has lost its power to control the rates.

 

As they no longer have any means to enforce the policy, they can only attempt to guide where they would like the interest rates to be in future. So even if they can move the funds target rate higher, their tools to enforce the decision is very limited.

 

So if I understand this correctly, if they want to return to a Fed funds target, they need to drain the trillions of excess liquidity that they have provided to the banking system.

 

To reduce the excess liquidity they could:

a) sell Treasuries / MBS (prob not going to happen since it would drive up short term rates above 3% so the fed becomes CF negative)

b) stop reinvesting maturing bonds (but the big maturities start at 2018 due to operation twist)

c) Make a deal with Treasury to swap long term holdings to short term (would probably shock the market and sink the credibility of USA)

d) Reverse repo (They can attempt to guide rates higher by increasing the repo rate. But yesterday when the FED made the repo, not only did it go above the 300 bn cap, the lowest rate of the auction was -0,2%, hence the repo was not effective and future repos will probably look the same).

 

And from here Im lost :-\

 

What are the FED going to do and how can they do it? If they cant reduce the excess liquidity relatively quickly, they will probably lose ability to respond to potential inflation.

   

[yadayada]

why would the fed become cash flow negative with higher interest? isn't their balancesheet enourmous by now?

 

The only way they cannot lower rates is if they cannot sell securities. If they cannot sell securities (they cannot make them out of thin air, but that is not a problem now) is if there are no willing buyers? And they can just make money to pay the coupon?

 

No willing buyers mean that there is low confidence in US government debt?

 

Also why would sudden inflation be a problem? I fail to see how this could happen suddenly. you would need

 

A: price increase in commodities like oil

B: low unemployment (means rising wages because more leverage for workers?)

C: productivity not going up while demand goes up.

 

Seems like A is unlikely. We are slowly moving towards solar and gas (very abundant) and moving away from oil in the next decade. And we can recycle metals

B is also unlikely because of C. Productivity is rising in farming, manufacturing and now in the services sector. So more will be done by fewer people. Which means things will become cheaper and less demand for human labor.