The Fed has it all wrong.
The lowest risk to the economy -- and to the Fed's wish to reduce its balance sheet -- is for it to sell bonds now and not raise rates. The Fed cannot take back last week's mistake of raising the Fed Funds Rate, but it could wise up and say that it will not raise rates again until it has stopped reinvesting interest and matured bonds, as it is still doing, and has gotten its balance sheet down to its new normal level. This would be a market-based method -- and a reversal of the quantitative easing (QE) and "Twist" (selling short-term Treasuries and buying long-term Treasuries to push down long-term rates) that brought market rates down to the low levels they attained.
The Fed is really off its game by raising rates before starting to reduce its balance sheet -- and in actuality, the Fed raised rates Wednesday while continuing to buy additional bonds for its balance sheet. How can this make any sense?
It does not make sense, if the Fed governors want to reduce the balance sheet to have ammunition for the next economic crisis.
QE and Twist got mortgage rates down to very low levels so that housing could recover -- which was a good thing. So why would the Fed not reverse the process now and sell bonds to take advantage of a market that wants the bonds very badly for many reasons?
I think the answer is that the Fed does not understand or trust markets. The banks all raised their prime rates alongside the Fed rate increase. This acts like a tax on all borrowers, with rates based on the prime rate. Had the Fed just stopped buying more bonds and said that they would be selling bonds soon, the market would decide if rates needed to go up -- and not the Fed, which has had a very bad record at predicting economic growth over the years.
The profit on the sale of the Fed's bonds will most likely be much lower if the Fed waits until they raise rates a few more time before they start selling bonds, unless the economy tanks and market rates go back down. But the Fed will most likely not sell bonds if that happens.
The Fed's plan is fraught with uncertainty over the possibility that no bonds will be sold or that reinvestments will be stopped if the economy tanks. The only sensible thing is for the Fed to sell bonds into the bond market now, while the market is still very strong and pension plans and insurance companies are in need of the Fed's bonds to fulfill their obligations.
