Why the Fed Can’t and Shouldn’t Raise Interest Rates

The Federal Reserve may be working within a basic policy strategy that may be fundamentally flawed.

by Timothy A Duy

The Federal Reserve eschews balance sheet policy – changes in the amount or composition of assets held by the central bank – in the early stages of its plans to normalize the extraordinary monetary policy it instituted in the wake of the financial crisis. Instead, the Fed’s normalization plans currently focuses on raising the federal funds rate. But the central bank may need to use both rate policy and balance sheet policy simultaneously to reach the objectives of its dual mandate – or price stability with maximum sustainable employment – while sustaining a financial environment consistent with those objectives.

The flattening of the U.S. yield curve as investors see little chance of rates rising in the longer term should serve as a red flag that their focus on short-term interest rates may be doomed to failure.

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