Editor’s note: The Federal Reserve’s policy-setting committee raised its benchmark interest rate by a quarter point to a range of 1 percent to 1.25 percent, the second increase this year. The central bank also indicated that it will likely lift rates once more this year. Given these developments weren’t exactly a shock, we asked a couple of Fed experts what was noteworthy about the announcement.

What’s the real risk

Sheila Tschinkel, Emory University

The Fed’s decision to raise the federal funds rate was no surprise to financial markets. Nor was its expectation of one more hike this year.

Even though core inflation has been below its 2 percent target, the economy’s underlying strength suggests little or no risk of recession or deflation.

The Fed also said it is ready to begin reducing its holdings of government and other securities later this year. As a result of “quantitative easing” – the purchase of mortgage-backed and government securities to reduce long-term borrowing costs – and other measures aimed at preventing a collapse of the financial system, the value of assets on its balance sheet ballooned to $4.47 trillion from $915 billion at the end of 2007.

The Fed seems to believe the bigger risk, actually, is that the economy could overheat, particularly if ultra-low rates are combined with government stimulus (which is still up in the air). The upshot is that the Fed seems pretty confident in the economic recovery and thinks it’s time to “begin the return to normal.”

Still, economic growth remains lower than many – including me – would like. It’s ranged from a disappointing 1 percent to 2 percent for the past few years.

The bigger risk facing the Fed might be that the economy is fundamentally not as strong the central bank believes it is. In that case, if the Fed continues to “normalize,” the economy could weaken and even go into recession.

Markets seem to reflect this view. Yields on 10-year U.S. Treasuries, for example, are actually lower than they were in November, even though the Fed has lifted its target interest rate by a quarter point three times since then. This suggests investors are still anxious about the state of the U.S. and global economies – or something entirely different could be at work.

Without a crystal ball, we don’t know which view is right. While I can’t explain why bond yields have declined, I do believe the U.S. economy is doing all right and the Fed is on a reasonable path to normal.

The Fed’s balance sheet quandary

William D. Lastrapes, University of Georgia

Today’s announcement provides the first glimpse into how the Fed hopes to downsize a historically huge balance sheet. In other words, how does it plan to reduce the $4.2 trillion in government bonds, mortgage-backed securities and other assets it holds?

The Fed plans to take a gradual approach. Essentially, the securities on the Fed’s balance sheet are continually maturing. As they do, the Fed has been taking the principal it collects and reinvesting it back in new securities. When the bank is ready to begin paring its holdings, it can simply stop reinvesting those proceeds, which will allow its balance to gradually decline. Or, if it would like to speed things up, it could sell some securities on the open market before they mature.

In other words, imagine your teen-aged self has seven $100 bills and you lend each to a friend in need on a different day of the week starting on Monday, for a term of seven days. Come the following Monday, when the first bill is repaid, you decide to lend it out to someone else and continue to do so indefinitely. Essentially your balance sheet would always show $700 in assets. Then, if you decided to unwind your little bank, instead of re-lending the bills you began keeping them as they came due, thereby gradually reducing your assets until they hit zero.

There’s a flip side, however, as for every asset there needs to be a liability. And for every dollar drop in assets on the Fed’s balance sheet there needs to be a corollary decline in its liabilities. For your mini-bank, that liability might be the $700 you borrowed from your parents. And so when you stop re-lending those bills, you paid them back to your mom and dad, reducing what you owe.

The Fed borrows its money from banks in the form of ‘reserves’ and so reduces these reserves when lending slows. And that’s where it finds itself in a serious quandary that could derail the economic recovery if not handled well.

Bank reserves – the safe and liquid cash assets that financial institutions hold as deposits at the Fed – currently total $2.2 trillion, up from $5.8 billion in the last week of December 2007. Almost all of these reserve holdings are excess reserves, which means they’re more than the Fed requires banks to hold in order to back up their deposits.

Why would banks keep so much of their portfolios in simple cash assets at the Fed and not in other securities or loans to businesses? One reason is that banks still desire safe and easily redeemable assets because of post-financial crisis regulations and other lingering effects of the crisis. And what’s safer than the Fed, right?

An even bigger factor is that the Fed pays a relatively high yield on those excess reserves, now 1.25 percent, which exceeds what banks could get in comparably safe, short-term investments elsewhere. Why invest in anything else when parking that cash at the Fed is profitable and there is absolutely no default risk?

The problem for Chair Janet Yellen and her colleagues at the Fed is that if they try to pare back its balance sheet, banks may respond by cutting back on their own assets, such as loans to businesses and consumers, which in turn causes checking deposits and the money supply to drastically contract. The consequences are serious and include deflation and even recession.

So why not just reduce the rate it’s paying to the banks so that they don’t want to leave so much of their money at the Fed and instead lend it out? Increasingly, the Fed has been using interest rates on reserves as a way to help it set monetary policy and control its all-important federal funds rate. So if it lowers the interest rate on reserves, that’ll make hitting market interest rate targets that much more difficult.

The Fed now seems to get this and noted in its announcement that it plans to move cautiously on normalization while paying attention to the behavior of banks. The buildup of the Fed’s balance sheet during the financial was unprecedented. And now, so is policy normalization. Fed policymakers are correct to be cautious in their approach.

The authors do not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and have disclosed no relevant affiliations beyond the academic appointment above.