Assume in parts (a) – (c) that the Fed has decided that a slow (50 basis points per year) rise in the Federal funds rate is likely the correct approach to balancing risks of holding inflation to around 2% per year while maintaining enough growth in GDP and labor markets to achieve and stay at full employment. However, even if this is the correct view, it may no be the view that financial markets, lenders and CEO’s take. (hint: read the material on policy normalization on the Federal reserve website under the tab “monetary policy”)
a) What problems might arise in controlling the Federal Funds rate and other money market short term rates to keep them in the Fed’s target zone as the Fed slowly raises that target zone given the fact that in the aftermath of QE1 through QE3, most banks hold substantial excess reserves?
b) How will the Fed’s ability to pay interest on bank reserves help it deal with these potential problems ?
c) How will short term repo market sales of Treasury securities from the Fed’s balance sheet help it keep money market interest rates and yields within the Fed’s fed fund target range as the Fed increases its Fed funds target?