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What Could Go Wrong Regardless Of What The Fed Does

Karen Shaw Petrou's memorandu to Federal Financial Analytics clients on what could go wrong regardless of what the Federal Reserve does.

TO: Federal Financial Analytics Clients

FROM: Karen Shaw Petrou

DATE: September 11, 2015

Markets watching the Fed are like kids watching a magician – they’re so focused on the watch in the right hand that they miss the rabbit going into the hat in the left one. Markets are fixated on inflation, employment, phases of the moon, or whatever else drives rate forecasts. Readying the rabbit for the hat, though, are the $2.5 trillion in excess reserves banks now secure at the central bank. As a paper we released this week lays out, any missteps in monetary policy will flow through these excess reserves like a firestorm. We learned in 2008 how closely linked financial stability is to monetary policy, and the FRB had better have this very much in mind now. If it doesn’t, its own actions could incinerate bank profitability and intermediation capacity with untold systemic effect.

Nominal rates below the ZLB mean that depositors pay bankers and bankers pay borrowers – that’s why negative rates are so amazingly worrisome. No one’s talking much about them, but that’s largely because policy-makers don’t like discussing issues like this in front of the “children” – that is, markets that might scream with undue delight or dismay...