The Federal Reserve Shouldn't Raise Interest Rates, It Should Reverse Quantitative Easing Instead

I’ve already mentioned this in passing today but it’s worth laying out why I think that raising interest rates would be the wrong decision this week. Instead, the Federal Reserve should be reversing quantitative easing. Do note that this would have very much the same effect so I’ve already agreed that monetary tightening should be taking place. It’s how that is done, the technique, that I am concerned about, not the specific policy aim itself.
It’s also rather too late for anyone to adopt my preferred policy because everyone is being geared up for the rate rise already and the expectation of it already built into market prices. But it is still, I think, a better policy for one single reason: granularity.

So let’s walk back to what the whole thing has been about. We wanted to have looser monetary conditions–that meant lowering interest rates. Once we’d got to near zero there wasn’t much lower we could go (it’s possible to have slightly negative rates, but not very negative rates) and thus quantitative easing. That is the Fed creating money to purchase low risk assets and thus raise their price and lower their yield. This pushes investors out into higher risk assets as they search for that elusive yield. That, in turn, lowers long-term interest rates which is what we wanted to achieve.
Note that this isn’t any different in principle from the normal open market operations the Fed uses to try and fine tune interest rates. Indeed, we could call QE simply the Mother of All Open Market Operations (not that MAOMO is all that impressive an acronym). And just as with those open market operations QE should and will work both ways. Reduce the assets held by the Fed and this will reduce the price of those assets being held and thus increase their holdings. That again will bring people in along the risk curve and so raise long-term interest rates.
As, also, raising interest rates directly will raise interest rates. So why prefer one method over the other?

Granularity: How fine-grained can you make the policy be? An interest rate rise is an all or nothing thing. Either you raise rates by 0.25% (and no one thinks it’s going to be in any units smaller than that) or you don’t. But we already know how the Fed intends to reverse QE in the long term.
Those bonds it currently holds mature over time. Indeed, some of them are maturing right now, as they have been in dribs and drabs for some years. Currently, as bonds mature the Fed goes out into the market and purchases more in order to maintain their stock. All they have to do to reverse QE is stop buying more as bonds mature. That means the borrowers, in order to roll over their debt, have to issue new bonds to the market. The Fed’s holdings reduce, the market’s increase and that’s a reversal of QE. And it also raises long-term interest rates in exactly the manner that the original purchases lowered them. Which brings us to that granularity.

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The Fed can do this in any volume it chooses. It could simply not replace $100 million’s worth each month. Or a billion’s, or $50 billion. It’s entirely at liberty to do as much or as little tightening as it wants. It thus has much more control over what happens to the markets than that all or nothing raise rates or don’t. And yes, by the way, they do indeed know how much replacement or not replacement of those maturing bonds would raise rates. Precisely because this is just a larger version of those open market operations they’ve been doing for near a century now.
It’s much too late for the Fed to change their minds and do this of course, but I do still feel that it would be a better way of managing things.