The Federal Reserve’s Open Market Committee (FOMC), which guides implementation of U.S. monetary policy, will report on Wednesday whether it will continue to “be patient” with low interest rates or foresees them “beginning to normalize” as early as June.

The personification of monetary policy is Fed Chair Janet Yellen. Until Wednesday’s FOMC release, money markets will gyrate on speculation about: does she, or doesn’t she (raise rates)? Beyond that, volatility will persist as the markets grapple with a new regime.

For the general economy (i.e., where goods and services transact), the timing of the first increase (e.g., June versus September) is less consequential than: what “normalization” entails (i.e., the timing and pace of changes); other Fed policies (e.g., the size of its balance sheet; interest paid, or charged, on excess reserves); and the regulatory climate (i.e., financial re-regulation).

Since September 2008, when the global financial system was at the brink of meltdown, monetary policy has been anything but “normal.” Instead, its scope has broadened and the instruments of implementation have expanded. Further, for those seeking financing – via equity or credit – the options (and costs) remain in flux due to an incomplete regulatory framework (i.e., key elements of Dodd-Frank).

Broadly speaking, the economy is flush with relatively cheap money due to the Fed’s “quantitative easing” (QE). Through QE, the Fed expanded its balance sheet [Chart 1] by using newly created funds to purchase risk-free assets – federal and federally guaranteed securities – from depositories. The resulting increase in system-wide liquidity exerted downward pressure on interest rates.

Since its inception, QE has added more than $3.5 trillion to the Fed’s balance sheet. About one-third has been extended to businesses and households; the rest remains on depositories’ balance sheets. Even were the demand for loans to surge, the surfeit of credit capacity would constrain a market-driven rate rise.

That is not to say that rates will remain near recent levels. Assuming the domestic economy continues to expand through 2015, market rates should trend upward; but other factors (e.g., weak external demand, currency valuations) may work to constrain the rise.

by Patrick J. O’Keefe
CohnReznick