Its been over 6 years of ultra low interest rates referred to as ZIRP, or zero interest rate policy. We have been told to expect a normalization of interest rates soon, but now we are told that the Fed, specifically the New York Federal Reserve Bank is trying to figure out how to do that.

For the millions of people who have suffered through an economics course the answer should be obvious, but for the Fed, things are not as clear as in the past.

It turns out that officials from the New York Fed have been asking traders, financial firms, and even other central bankers how they can increase the Federal Funds Rate by 1/4 of 1% without bringing the world financial system to its knees.

According to a Reuters report:

The trouble is that the federal funds market, the intra-bank trading pool traditionally used by the Fed to meet its policy goals, has shrunk to about a quarter of its pre-crisis size after more than six years of unprecedented monetary stimulus.

“There is a lot more uncertainty in the mechanical features of the outlook than people admit to,” said Joseph Abate, a money-market strategist at Barclays Capital.

The Fed wants to avoid a scenario in which yields don’t rise enough after it lifts the fed funds rate because banks, flush with $2.5 trillion of reserves parked at the central bank, don’t need short-term funding.

The central bank also risks being drawn so deeply into money markets that it destabilizes things.

That’s why the New York Fed, already under political pressure due to regulatory missteps, is taking every precaution it can to protect its credibility and that of the central bank. It wants to make sure that when the central bank decrees higher rates, yields will actually rise.

In addition to the dangers of associated with the mechanics of Fed-distorted credit market, Fed officials are also worried about a higher US dollar which might hurt exports and endanger foreign currencies, especially in emerging markets. Oh, what a tangled web the Fed has woven.

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