Daniel Munoz / Reuters Office workers are reflected on a screen displaying share prices, September 23, 2011.

For the Fed, Mop Not Hike

Cleaning Up Excess Reserves Rather Than Raising Rates

By the most recent forecast, the U.S. Federal Reserve is set to raise interet rates on December 16. That it’s happening in the midst of a global economic slowdown is bad news for markets and economies around the world. Even China’s yuan, which had remained stable alongside the strengthening U.S. dollar until recently, had to decouple from it in August to bolster the country’s faltering export industries; it was another decision that shook markets worldwide.

Federal Reserve Chair Janet Yellen has been warning of the coming interest rate hike for some time now. She wanted to sound the alarm sooner rather than later because the Fed has injected some $2.5 trillion in excess reserves—17.6 times more than the statutory reserves needed to support the present level of U.S. money supply and lending activity. When a central bank has created such an unprecedented degree of liquidity, particularly with the U.S. economy doing relatively well, inflation could accelerate much sooner than in the past once the private sector is ready to borrow money again. That could force the Fed into an abrupt tightening, which could be very damaging to the market and the economy. The Fed must also avoid creating the impression of being behind the curve on inflation lest it trigger a bond market crash that could send long-term interest rates rocketing.

U.S. Federal Reserve Chair Janet Yellen testifies before the Senate Banking Committee on Capitol Hill in Washington, July 15, 2014.

In spite of the United States’ relatively strong economy, inflation remained subdued because the private sector still maintained a financial surplus of over six percent of GDP, at least through the year ending in the third quarter of 2015, according to the flow of funds data. This is worrying because it means that the private sector continued to save in spite of zero interest rates, a disturbing trend that began when Lehman Brothers collapsed in 2008. It also indicates that businesses and households are still recovering

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