A Serious Warning From the Federal Reserve about Interest Rates

This gets a bit technical, but the Federal Reserve is flashing that there could be serious, I am talking major league serious, interest rate hikes down the road.

The first clue to this was last week Thursday's report out of FT that the Fed may use mutual funds as a source to shrink Fed reserves by conducting reverse repurchase agreements with the the funds. When something like this is leaked by the Fed, they are trying to alert the markets so they won't be surprised by such a move when it occurs. As I wrote last week, I saw one reason for this move as the Fed:

...contemplating doing this, if banks start to lend against excess reserves, as a back up to Bernanke's plan to control money growth via the interest rate it pays on excess reserves.

Okay, so the Fed has a back up plan, but now there is an interesting story in WSJ's weekend edition headlined: Official Sees Aggressive Rate Boosts in the Offing. The story reports:

A senior Federal Reserve official said the central bank could push interest rates up more aggressively than usual when it decides to shift away from its easy monetary policy.

Fed officials have gone to great lengths in recent weeks to reassure investors that they will keep interest rates low for "an extended period." Until now, they haven't articulated how aggressively they would move once interest-rate increases do kick in.

"When the decision is made to remove policy accommodation further, prudent risk management may prescribe that it be accomplished with greater swiftness" than is customary, said Kevin Warsh, a Fed governor, at a conference on banking Friday at the Federal Reserve Bank of Chicago.

Mr. Warsh was a close adviser to Fed Chairman Ben Bernanke during the financial crisis

I think the signal from Warsh, and that's what it is a signal, and the leak about doing reverse repos are related in this way. During a speech in July, Bernanke made it clear the interest rate now being paid on excess reserves would be a key to controlling money growth:

Perhaps the most important such tool is the authority that the Congress granted the Federal Reserve last fall to pay interest on balances held at the Fed by depository institutions. Raising the rate of interest paid on reserve balances will give us substantial leverage over the federal funds rate and other short-term market interest rates, because banks generally will not supply funds to the market at an interest rate significantly lower than they can earn risk free by holding balances at the Federal Reserve

But here is the problem, which Bernanke must realize given these leaks. The banks are keeping so much money with the Fed as excess reserves because it is currently the best alternative. When real rates rise, this may not be the case, and banks may lend out those excess reserves, thus exploding the money supply. At such time, the Fed may have to drain reserves very quickly (thus the leak about using mutual funds as away to drain via reverse repos), or raise rates rapidly (thus the Warsh warning about a rapid rate hikes), to stem an otherwise explosive growth in money supply.

This isn't likely to occur in the very near future since the Fed's current tight money policy is creating a near deflationary environment where real rates are low, but any money printing down the road as a result of a misguided attempt by the Fed to manipulate the economy into an unsustainable structure, or as a result of the Fed supporting the Treasury market, could result in very rapid interest hikes.