Everybody hates rules but this is a breakthrough policy to free the fearful Fed.
The Federal Reserve Board (Fed) has held the Fed Funds Rate (the interest rate the Fed charges banks) below 1 percent for 7 years. That is unprecedented. The Fed originally lowered the Fed Funds Rate to 0.25% to counteract the last Great Recession.
When the Fed lowered its primary interest rate, it also started Quantitative Easing (QE) by buying securities in order to pump money into the economy to stimulate it. Now the Fed has stopped buying securities via QE.
The next step according to the standard Fed playbook is to raise the Fed Funds Rate, completing the unwinding of the previous actions.
Unfortunately the Fed Funds Rate has not risen to normal levels because the Fed is afraid to hurt the economy.
What Is Normal?
According to the above website, if the Fed wanted the Inflation Target to be 2%, then the Fed Fund Rate should be 2% plus 1.44% or 3.44%. Then 3.44% should be the normal Fed Funds Rate.
What Are The Fed’s Options?
How does the Fed get back up to the normal 3.44% Fed Funds Rate? It can do one of these:
1. Reverse QE by selling securities OR
2. Set the long-term interest rate to set a goal OR
3. Simultaneously raise the Fed Fund Rate AND offer another round of QE.
Ideally, the Fed should have raised the Fed Funds Rate while phasing out QE from 2011 to 2014.
The best is option 3 which has the most influence and least fear.
But How Fast?
A return to normal Fed Funds Rate involves small baby steps in a gradually higher Fed Funds Rate while offering a phased out QE.
If the Fed only raised the rate .25% each quarter, it would take 13 quarters or over 3 years to get to 3.50%.
Kelley Monetary Policy Rule
The Taylor Rule involves raising the Fed Funds Rate 1 percent for each 1 percent in inflation. We have no inflation so the Taylor Rule is of no help. The Kelley Monetary Policy Rule states the Fed Funds Rate will be increased gradually and QE will be reduced gradually to zero at a rate inversely proportional to the Fed Funds Rate.
This should eliminate any fear by the Fed or the financial market and get us back to normal.